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Impact of Interest rate on Currency value

Published on Thursday, September 05, 2013
On of the important questions asked in bank exams interviews is what is the impact of interest rate on currency value. Value of currency is depend upon it's demand and supply. If supply increases its value decreases and if demand surpasses supply it's value increases.

So if interest rates in increases in India, value of INR (Indian Rupees) decreases and if interest rates falls, the value of INR increases.

Let me explain this with an example. In this example it is assumed that interest rate is the only factor that impact currency valuation. All other factors are assumed to be constant.

Example

Sohan is running a web development company from Delhi. As he delivers high quality in his projects, he got a big project of $1000. As per terms of contracts full payment will be made after one year when the project will be completed. Now Sohan is tensed about volatility of INR as he i living in India and spends INR. He went to his know the impact of interest rates on currency value.

Sohan's friend Ramesh who is a financial analyst explained him via three scenarios as given :-


Assume annual interest in both India and US is 8%

If Interest rates remains same :-

ParticularsIndiaUSA
Interest Rate8%8%
Currency valueINR 60/$


Sohan will take a loan from a bank in USA on January 1, 2013 of the value which he will get after 1 year.

So 

$1000 * 100/108 = $926

Now Sohan will deposit the $926 in an Indian bank at 8% interest rate.

$926 * 60 * 108/100 = INR 60,004 ( Get this amount on December 31, 2013 by which he will pay the loan back)

Value of INR = INR 60/$

From the above illustration it is clear that if interest rates of two countries are same then the value of currency remains stable.

If Interest rates decreases

ParticularsIndiaUSA
Interest Rate4%8%
Currency valueINR 60/$

Now Sohan will take a loan as explained above @8% from a US bank.

Sohan will deposit the money in the Indian bank @4%

Sohan will get 926* 60*1.04 = 57,782

Value of INR = 57,782/1000 = 57.782/$
Now the value of currency increased.

If Interest rates increases


ParticularsIndiaUSA
Interest Rate12%8%
Currency valueINR 60/$

Now Sohan will take a loan from a US bank @8% from a US bank and deposit the proceeds in an Indian bank @12%.

He will get 926*60*1.12 = INR 62,227

Value of INR = 62227/1000 = INR 62.22/$
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ramandeep singh

Ramandeep Singh, your guide to banking and insurance exams. With 14 years of experience and 5000+ selections, Ramandeep understands the path to success, having transitioned himself from Dena Bank and SBI. He's passionate about helping you achieve your banking and insurance dreams.

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