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The IFE operates under the assumption that real interest rates are equal across countries when adjusted for expected inflation.

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How Interest Rate Changes Affect Exchange Rates

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How Interest Rate Changes Affect Exchange Rates

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Currency Appreciation: When a country's nominal interest rate is lower than that of another country, its currency tends to appreciate. Investors seek higher real returns in countries with lower inflation, increasing demand for the domestic currency.

Currency Depreciation: When a country has a higher nominal interest rate, its currency tends to depreciate. The market expects higher inflation, reducing the currency's purchasing power over time.

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Stronger Domestic Currency (Appreciation):

Imports Increase: Imported goods become cheaper for domestic consumers.

Exports Decrease: Domestic goods become more expensive for foreign buyers.

Weaker Domestic Currency (Depreciation):

Imports Decrease: Imported goods become more expensive.

Exports Increase: Domestic goods become more attractive to foreign markets.

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1. U.S. vs. Japan:

If U.S. interest rates rise relative to Japan, the USD is expected to depreciate, making Japanese imports more expensive and U.S. exports more competitive

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2. Eurozone vs. UK:

If the UK has higher interest rates than the Eurozone, the GBP should depreciate over time, making EU imports costlier for the UK and UK exports more attractive to EU buyers.