The Relationship between the Exchange Rate and the Interest Rate

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    The Relationship between the Exchange Rate and the Interest Rate

    • If the UK’s exchange rate rises, export prices in terms of foreign currencies will rise
      • Demand for exports will therefore fall, reducing AD
      • This lower AD will reduce inflationary pressure
      • This lower inflationary pressure could mean that the MPC will reduce the interest rate.
    • A reduction in the UK’s interest rate is likely to reduce the exchange rate
      • This is because a lower interest rate will reduce the return on money kept in UK financial institutions
      • This is likely to cause an outflow of funds to other countries, to take advantage of higher interest rates
      • This will mean more of the currency is being sold, and this increased supply will lower the exchange rate.
    • This relationship is not always true though.
      • A cut in the rate of interest in the UK could make foreigners more confident about the prospect of UK economic growth
      • They will then want to put money in UK financial institutions, increasing the demand and increasing the exchange rate.

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