Macroeconomics - IG Exchange Rate

 Macroeconomics - Exchange rate

Case Study - Hypothetical                            Example - 1

Level - IGCSE     

Interest Rates

(source - https://www.bankofengland.co.uk/boeapps/database/Bank-Rate.asp)

The chart above shows the different bank rate set by the Bank of England in different years. The rate of interest has risen from 0.5% at the beginning of the year to 4% by the end of the year 2022.

Discuss the probable effect of rise in bank rate on the UK`s currency.

Possible answer - 

Before getting into the discussion let us know what is bank rate. Bank rate which is also called the base rate is an interest rate set by the central bank of England to charge for lending money to commercial banks or to pay for borrowing money from the commercial banks.

Generally, central bank changes the interest rate to encourage or discourage the consumption in the economy to control the inflation. Interest rate is decreased to encourage consumption, whereas, increased to encourage saving. 

As we can see from the chart above the interest rate has been increased by the Bank of England from 0.5% (beginning of the year 2022) to 4% at the end of the year 2022. 

This increase in interest rate will definitely encourage domestic population including foreigner savers to deposit and save their money in UK as it will grow their money further on the principal. Foreigners will be attracted to save money in UK if the interest rate in UK is comparatively higher than other countries. This inflow of money from outside the country due to relatively higher interest rate is called hot money. Nonetheless, 4% interest rate in UK would always be attracting for savers as the interest rate in UK did not go up more than 0.75% in last 10 years. 

Though it is an attractive rate for foreigners but they won’t be able to save their money directly into UK as their currency may not be the same as UK`s currency. That means, foreigners first have to buy the UK currency and then save it in UK in order to enjoy the benefit of higher interest rate in UK. 

As a result of this incident, demand for UK currency in the Forex market will increase leading to an increase in the price of per pound. This will lead to value of UK currency to increase and therefore UK currency to appreciate. Conversely, the UK currency will depreciate if the interest rate in UK falls.

So this is how we see the change in interest rate might affect the UK currency either by forcing it to appreciate or to depreciate.