The Effects of Interest Rate on the Dollar

by Keith Evans

Investors and consumers often pay close attention to interest rates, as even slight variations in interest can cause dramatic effects on the dollar. While high interest rates typically raise the value of a dollar, a number of factors contribute to the effects of interest on the value of U.S. currency.

Low Interest Short-Term Effects

When nominal interest rates fall, consumers gain a considerable amount of purchasing power that equates to a stronger dollar in the short term. With low rates, consumers often feel good about taking out loans to make big-ticket purchases like cars, homes and furniture. These big-ticket items stimulate economic growth, spurring employers to hire additional help and raise the country’s overall spending power. The Federal Reserve Bank of San Francisco points out that low interest rates tend to reduce the value of the dollar on foreign exchange trades, lowering the price of domestic goods and raising the price of imported goods. As a result, consumers gain a more powerful dollar as a short-term effect of low interest rates.

Low Interest Long-Term Effects

Though low interest rates tend to lead to a more powerful dollar in the short term, prolonged periods of low interest rates can spur inflation that weakens the value of a dollar. Investors tend to put more money into stocks rather than bonds during periods of low interest, giving employers the ability to expand payroll expenditures. A greater number of workers earning higher salaries creates additional demand, and this demand causes prices to rise over a period of time.

Foreign Investments

Investors often pay close attention to interest rates, as rate parity tends to cause the dollar to move in the opposite direction from rates over time. Low interest rates tend to cause foreign investors to favor investment vehicles other than U.S. currency because of reduced profits, causing money that would otherwise flow into the economy and strengthen the dollar to find placement elsewhere. Coupled with the tendency of low rates to cause inflation in the long term, the effects of foreign investments can have a considerable impact on the value of the dollar.

Considerations

Just as reduced interest rates can cause foreign and domestic investors alike to favor other currency, high interest rates can create a cash infusion in the general economy. During short periods of low interest, entrepreneurs, farmers and other business owners may obtain access to loans that would be out of their reach during periods of higher interest rates. This additional capital tends to spur economic growth and create increased short-term purchasing power for newly hired employees. The Federal Reserve often has difficulty forecasting the long-term effects of interest rate changes, according to the Federal Reserve Bank of San Francisco, so the Fed often makes minor adjustments to the nominal rate in an effort to control inflation.

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