Introduction

There is general consensus among scholars and professionals alike, that the world’s economy is getting more inter-dependent because of the spread of globalization (Mander 2014). However, as the global economy becomes more integrated, the importance of exchange rates in this economy is getting more vivid. Countries have to trade with each other because of things like comparative and competitive advantage in production. However, there is no common denomination in which they can trade, so they need to exchange currencies. This paper therefore examines the influence of macro environmental forces like interest rates, inflation and the balance of payment on the interest rates. The focus of the study though, is the US and the UK. The structure of the literature review is as follows: first, the concept of interest rates is discussed and then its impact on interest rates is explored from the point of view of previous researchers. The same format is followed when analyzing the inflation rates and balance of payments. Lastly, the conclusion of the literature review highlights the main points of the study.

Literature review

Exchange rates

Exchange rates are the rate at which the currency of one country is traded for that of another country (Hericourt & Poncet 2015). Considering that each country has a unique currency which it uses (except with regional economic integration), international trade requires these currencies to be exchanged at a predetermined exchange rate.

These exchange rates can affect the economic performance of a country on a great scale. For example, currency appreciation can reduce the amount of exports of the country because they will be expensive. On the other hand, the depreciation of a currency can make the exports of a country cheaper and that would increase their demand (De Grauwe 2016). With the increase in the demand for exports, aggregate supply and GDP would increase and that would elevate the levels of employment in the country. Resultantly, there is some visible growth in the economy as a result of this depreciation.

However, it is not recommendable for the currency to sway to the extremes of the bipolar continuum of the currency changes. If the currency depreciates too much, then it will hurt the economy by making the imports of raw materials too expensive. Basing on the theory of comparative advantage, every country needs to import some of its raw materials as well as goods and services occasionally. Likewise, too much depreciation would create a balance of payments deficit as it would deter foreign investments. On the other hand, if a currency appreciates too much, it could hurt the terms of trade of the country. For example, the exports of the country would be very expensive and this would lead to very low demand for them. Even if the country would be able to import the inputs cheaply, this might be a disservice to the economy because it would induce overproduction (Krugman et al. 2015).

The implications of the exchange rates on the economy have therefore dissected the foreign exchange policies of the world. There are exchange rates which move freely with the changes in the demand and supply of the currency, and those which are fixed by the governments. The exchange rates which are dictated by the market forces are called floating exchange rates while the exchange rates which are controlled by countries are called fixed exchange rates. There is also another type of exchange rate which is known as the pegged rate. This rate is pegged by the central bank against the movements of another currency.

It is also important to note that currencies also have the power to affect the profitability of multinational companies or any other international trader. For example, if McDonald’s has made annual profits in Germany which it has not yet transferred to its home country. If, at the date of the conversion from the Euro to the dollar, the Euro appreciates, then McDonald’s will make a currency gain because it will have more dollars for its Euro. The reverse is also true. In another instance, Barclays may have issued loans in dollars to a large multinational. However, during the period during which the interest and the principal is being paid, the currencies will fluctuate. If the dollar appreciated, Barclays will be making currency losses because after conversion, it will have less pounds than it had originally expected to gain. Alternatively, say GE acquired a German company for €100 million on 12^th August 2016 when the USD/EUR rate was 0.8. If GE is going to settle the payment on 1 September 2016, and on that day the USD/EUR is 0.6, then GE will lose an extra $17.8 million in the excess payments which it will be making.

Foreign exchange can be traded in various ways, which have been classified according to the time frames during which the transaction is completed (De Grauwe 2016). The spot exchange rate is the rate at which the currencies are exchanged in real time. For example, if someone went to a forex bureau and exchanged yen for dollars, the rate at which they would be sold to him would be the spot rate. The currency futures on the other hand, refer to the rate at which different parties agree to exchange currency on a future date. For example, if a company is receiving a consignment of component parts in 30 days and wants to hedge against currency volatility, it can use futures to achieve this. It would go to a forex vender and negotiate a rate at which to buy the required currency on that date in the future. Lastly, a currency forward is the rate which two or more parties agree to transact with on a given date in the future. For example, if a foreign company wanted to buy inventory from a US company on a future date, the two could agree on a given rate at which to exchange their products regardless of the actual market price.

To evade the adverse effects of currency volatility, some individuals and companies participate in currency hedging (De Grauwe 2016). In other words, they are hedging against the risk of having to lose money to currency volatility. To that end, one of the most used tools is a currency forward contract. In the forward contract, the people who are going to be involved in the transaction agree that one is going to buy whatever it is they are buying, from the seller at a given exchange rate regardless of what the prevailing market rate is. For example, if GE was buying that company and decided that it was paying the money on a given date and the exchange rates are different on that date, then GE would still pay at the rate on which it agreed.

Interest rates

Interest rates are the returns which an investor expects to earn from lending or saving their money. On the other hand, they can mean the charges that a borrower has to pay for borrowing money. In the macroeconomic setting, interest rates are a monetary policy tool which is used by central banks to influence the supply of money in the economy. These interest rates can either be nominal or real. The nominal interest rate is the interest rate which an investor expects to earn from their savings or what a borrower expects to pay on their borrowing before adjusting for inflation (Mankiw 2014). On the other hand, the real interest rate is what an investor expects to earn, or a borrower expects to pay on their borrowing after adjusting for inflation.

In case of an expansionary monetary policy, the central bank increases the supply of money in the economy by reducing the interest rates so that the banks can lend at lower rates (Mankiw 2014). With the lower lending interest rates, the private sector and individuals can borrow more. This would increase the amount of money in supply in the economy, thereby boosting the employment rates and consequently, aggregate demand in the economy. On the other hand, if the inflation in the economy is exceeding its target, then the central bank can increase the interest rates, this would reduce investment in the economy, the employment rate, and lastly, the aggregate demand in the economy.

Noteworthy, there is a relationship between interest rates and inflation, as illustrated in the Taylor rule. This rule postulates that the interest rate which is set by the central bank should be based on the amount of inflation in the economy (Brancassio & Fontana 2013). The equation below illustrates the Taylor rule:

where i represents the federal funds rate, T is the target, p is the inflation rate, p^* represents the inflation rate being targeted, Y is the actual GDP, and Y^* is prospective GDP, while a₁ and a₂ represent the policy parameters.

In other words, the nominal interest rate should directly respond to the deviation of the actual level of inflation from the targeted level of inflation. However, it is also based on other variables namely, how much below or above the full employment level the economic activity is, and the short term interest rate which would be consistent with full employment. Basically, the Taylor rule recommends a tight monetary policy through a high interest rate if the inflation rate is above the target. Alternatively, if the inflation is below the target, then the rule recommends a loose monetary policy through imposing lower interest rates. One might notice that the other two variables are missing in the recommendations of the Taylor rule. However, the interrelationships between these variables ensure that the interest rates influence the other two variables. For example, if the interest rates are high, then the economic activity is likely to be closer to full employment because of an increase in investment.

Notably, there are times when interest rates control through monetary policy fails to achieve the desired economic boost. This has recently been the case in Europe, where banks reduced the interest rates to nearly zero but the economic recovery failed to reach the desired goals. Resultantly, the central banks resorted to quantitative easing. This quantitative easing is the process where the central banks directly inject new money into the economy to revive it. They buy securities form banks in order to induce the them to buy more assets with which to replace the ones which the central bank will have bought from them. This revives the stock market because the demand for financial assets will have increased. Consequently, this boosts investment in the economy and this investment is expected to revive the currency value.

Impact of the interest rate on the exchange rate

The interest rates affect the exchanges rates through various mechanisms. If for example the central bank increases the interest rates, the currency of the country will appreciate. When the interest rate increases, it becomes more profitable to invest in an economy because the investors will get more returns for their money. Resultantly, when the interest rates are raised, then more people will be buying the currency of a given country in order to save their money there. For example, if the interest rates in the UK increased by 2%, the investors would expect to earn 2% more than they were earning on their pound investments. This would drive them to demand for more pounds, and this demand would drive the price of the pound higher, as illustrated in figure 1. On the other hand, if the interest rates decline, then people have less on an incentive to save. This might either stagnate the demand for the currency of a country or depreciate it, if all the other factors are held constant (Burda & Wyplosz 2012).

Figure 1: Changes in the demand of the pound after a rise in the interest rate

This confirms Gandolfo’s (2013) postulation that the rise in interest rates leads to the appreciation of a country’s currency. However, this is only applicable to economies with floating foreign exchange policies.

Alternatively, the interest rates can affect the exchange rate of a country by influencing the amount of investment. If the interest rates are high, the people in the economy have an incentive to save more of their money. This avails with the banking institutions with more deposits which to lend to business people and companies. When these people have access to the necessary funds, they can expand their businesses and in the long run, the domestic market will have gotten saturated. At such full capacity, the domestic investors will venture into international markets and they will be exchanging their local currencies for the foreign currencies. However, this does not depreciate their domestic currency because of the eventual repatriation of their income, which is translated into their home currency. This in return makes their home currencies appreciate.

Likewise, an increase in the interest rates over the long and medium term develops a culture of saving among the people. This is because the opportunity cost of spending the money increases every time the interest rates increase (Mankiw 2014). Resultantly, people begin to save more and more of their money, and this causes a slump in aggregate demand. This has two types of effects. The first effect is a direct one in that the scarcity of the money within the economy will lead to its demand exceeding its supply. This will then cause the currency to appreciate. On the other hand, the low aggregate demand might lead to a decline in the quantity of imports. If the country in question maintains a large terms of trade deficit, the decline in the value of imports can lead to currency depreciation. This depreciation would be a result of the decline in the demand of the currency of the economy because of the decline in imports. However, both the UK and the USA have consistently had incremental import values over the period of this analysis (10 years) as indicated in figure 2 below.

Sources: Census.gov and ons.gov.uk

This indicates that the changes in the interest rates have not been substantial enough to affect the rates of importation in the country (even when they declined). It is also important to note, that this depreciation would only occur if the value of the imports which are being inhibited by a decline in the aggregate demand exceeds the value of the foreign savings which drive up the demand for the currency in question. In other words, the effect of the interest rates on the exchange rates is a symbiotic ecosystem which is influenced by various underlying factors, as indicated below.

Inflation

Mankiw (2014) defines inflation as the general rise in the prices of commodities in the economy. The central banks of particular economies usually have target rates of inflation for a given period of time. In both the UK, the target inflation for this fiscal year is 2%. The inflation is classified my most scholars (e.g Goodwin et al. 2013 and Farrell & Newman 2014) into two types, namely cost push inflation and demand pull inflation.

In the case of cost-push inflation, the general rise in prices is caused by an increase in the cost of production. For example, if there is a scarcity of labor in the economy, the wages will go up. To maintain their profitability, the producers will increase the prices of their products. The result of this move would be an increase in the general prices of goods and services in the economy. Alternatively, demand-pull inflation is caused when aggregate demand exceeds aggregate supply. This demand would therefore push the value and consequently the price of the products in the economy upwards.

Even if excess inflation can harm the economy, having inflation a very low inflation rate, or deflation rate can also be harmful to the economy. This is because inflation is considered to be one of the drivers of economic growth. It is therefore for this reason that countries set target inflation rates. These target inflation rates are usually positive because inflation, when managed, can induce economic growth by increasing the value of investment in the economy, and therefore increasing the GDP. Noteworthy, GDP is the main indicator of economic growth in economics according to Argy (2013).

The case of the general prices in an economy remaining constant is undesirable because the labor force requires occasional salary increments. In case the general prices remain the same over a long period of time, there would neither be incentive nor funds for the organizations to increase the salaries of the labor force. Resultantly, the labor force might get disillusioned with the stagnation in their general salaries and this would affect the quality of labor. Consequently, to accommodate the increment in the salaries of the labor force, the central banks all over the world agree that managed levels of inflation are necessary (Kremer et al. 2013).

The impact of inflation on the exchange rates

If the inflation in a given country is relatively lower than that of other countries, then the products of that country are going to be cheaper. The fact that these products are cheaper than those of countries with higher inflation will attract customers to the products of such a country. Consequently, the demand for the currency of the country in question will rise and that will cause currency appreciation. Alternatively, if the inflation in a given country is higher than that in other countries, then the currency of the currency in question might depreciation. This depreciation would be a result of the decline in the demand for the currency of the country in question because of the decline in the demand for its exports. However, there are other factors which must be taken into consideration with this postulation. For example, the country in question might have comparative advantage in some of its outputs. Likewise, the country in question might have trade agreements with its key importers. These trade agreements could leave its products cheaper despite inflation, because of the lack of tariffs, and possibly because of market proximity. For example, before Brexit, Britain was part of the EU integration. This would ensure that its exports would remain cheaper than those of Brazil despite the inflation because of its membership and the proximity to the aforementioned market (Balasa 2013).

The inflation rate can also indirectly influence the exchange rates by influencing the interest rates of an economy. Usually, when the inflation rate increases beyond the target of the central bank, then the same central bank tries to bring that inflation down by increasing the interest rates. The increase in these interest rates then reduces the amount of spending in the economy because of the high opportunity cost of spending as opposed to saving (Barnanke et al. 2015). This amount of saving would give the financial institutions more deposits to lend to prospective investors or assets for a return. However, considering that the interest rates will be higher, the rate of borrowing would be lower according to Wright (2012). The summative culmination of this scenario is that the demand for the currency will increase because of its scarcity. This demand therefore makes the currency appreciate.

The above two postulations are based on the assumption of controllable inflation and stable economic growth. However, if the inflation is excessive to the extent that was faced in Zimbabwe, then it is bound to crush the currency of the country. Excessive inflation can drastically devalue the currency of a country (Weale et al. 2015). Consequently, the exports of the country also decline drastically, apparently because buying the currency of the export destinations was too expensive. In such a scenario, even the local markets would collapse because the cost of items would be too expensive for the citizens to afford. This would inhibit the profitability of the imports and therefore, reduce the demand for the currency of the country even farther.

The impact of inflation on the interest rates is also contingent on the amount of central bank or government interference with the foreign exchange of a country (Ezrow & Helwig 2014). If the exchange rate is left to float freely, then the postulation that inflation affects it is a fact. This is because the currency prices are left to change with the market forces and inflation is one of these forces. Both the US and the UK have freely floating currencies without the direct intervention of their central banks. Consequently, the previous argument applies to them both. However, I the economies where the exchange rate is controlled by the authorities, it is possible for the authorities to ignore the inflation and fix the interest rates as they please

For the entire discussion, the impact of inflation on the exchange rates has greatly been based on the internal perspective. However, there is a lot of scholarly evidence pointing to the fact that the economic environment in one country affects the economic environment in other countries (e.g. Ezrow & Helwig 2014; Farrell & Newman 2014). Moreover, this state of affairs has greatly been exacerbated by the rise in the extent and scope of globalization. Consequently, the inflation rates in the countries which are the trading partners of the USA and the UK also affects the exchange rates of these countries. Presently for example, China is the leading export partner of the US (Trade in goods with China 2016). However, the rapid economic growth in China has proven inconsistent, something which is threatening the economic stability of the US. As the overproduction pushes the inflation rates of China higher, the US companies which had made it a trend to offshore their production there are in peril. The inflation threatens to increase the cost of labor. If this happens, then the companies might have lower profits to repatriate to the US. Considering that these companies are making substantial portions of their income in China (Morrison 2014), a reduction in the amount of repatriated funds would dampen the demand for the dollar. From a different perspective on the issue, these offshoring companies usually export their products from China back to the US, the most famous one being Apple. If the costs of producing in China rise, their products will become more expensive and as the law of demand predicts, this will dampen the demand for their imports. If this happens, then the reduction in the volume of the imports will reduce the demand for the dollar and this may lead to a depreciation of the dollar.

Balance of payments

The balance of payments refers to the values of the payments into an economy and outside of the economy. The money that is coming into an economy is credited and the money which is going out of the economy is debited. The money which is coming into the economy may be as a result of exporting goods or services, purchase of national securities by foreign individuals and governments, or repatriation from foreign markets by multinationals, to mention a few. On the other hand, the money which goes out of the economy also follows the same track. If the outflows of money exceed the inflows, that is known as a balance of payments deficit. If the opposite is true, then that is a balance of payment surplus (Wray 2015). Even if the surplus is more desirable, the ideal balance of payments should be zero according to Goodwin et al. (2013), but in reality, that is an impossible position to achieve. Noteworthy, the balance of payment has three parts namely the current account, the capital account, and the financial account.

Current account

The current account is tasked with marking the inflow and outflow of cash which comes from the exchange of goods and services in the economy. However, even the goods and services which are given away, for example in the form of aid, are also classified as current account items. According to Frydman & Phelps (2013), the value of the goods and services which are transacted or exchanged between a country and its counterparts is called a balance of trade. Conceivably though, this balance of trade makes up the greatest percentage of the balance of payments. The income or outflow which is received from assets which generate income, such as stocks, is also attributed to the current account. Lastly, the component of unilateral transfers is also attributed to the current account. These unilateral transfers include remittances from and to other countries by their nationals, as well as grants.

Capital account

The capital account mostly eponymously deals with capital inflows and outflows in an economy. The transactions which are recorded in the capital account include financial assets by people who are entering or exiting the country, the transfer in the ownership of some fixed assets like plant and machinery, the uninsured damage on any fixed assets, and the transfer of money after the sale of fixed assets, to mention a few.

Financial account

The financial account deals with the flow of money from investments in things like real estate, securities, investment in business, foreign direct investment, foreign reserves, and special drawing rights in the IMF.

The impact of the balance of payment on the exchange rates

The balance of payments affects the exchange rates in a variety of ways. First, the balance of trade determines how much the currency of an economy is demanded for. The dominance of the US in international trade can be posited as one of the reasons why the dollar has remained one of the most dominant currencies in the world. However, if you look at the historical export figures of the US in figure 3 below, it shows that the relationship between the dollar index and exports is inconsistent. The dollar is an internationally accepted currency, and this fact is likely to distort the real relationship between US balance of payments and the changes in the value of its currency. Besides that, the fact that it is usually held in large quantities by countries like China also explains the partial inconsistency.

Source: Census.gov

The financial account of the BOP also affects the exchange rate of a country. The trend of foreign investment in securities is on the rise both in the UK and in the US. This is due to the expansion of emerging market multinationals like Samsung, Go telecom and Lenovo. However, to buy these securities, the investors have to use the currency denomination of the country in which they are buying the securities, and this increases the demand for the currency of the host country. The financial account also takes into account the foreign reserves, as mentioned prior. If a country buys so much of another country’s currency for foreign reserves, then the currency of the other country is likely to rise because of the increase in its demand. In fact, some countries have been accused of using this tenet of the balance of payment to influence the currency movements of other countries. For example, it was alleged at some point that China was hoarding US dollars in its foreign reserves just to influence the value of the dollar (Hung 2013). In other words, if a country intends to drive the value of one currency up, it can raise its foreign reserves for that currency. When that happens, the scarcity of the currency in the market, and the increase in its demand automatically drive up its price. Noteworthy, several scholars concur on the unethical undertones of this practice as well as its lack of sustainability (Hung 2013). However, a country may do this in order to make increase the cost of the exports of its competitors in the international market. In doing so, the products of the country with the lower value currency would be favored over those of the other.

Conclusion

In synopsis therefore, it has been established that there is a great level of interdependence between interest rates, inflation, balance of payments, and the interest rates. The interest rates mainly affect the interest rates by influencing the amount of foreign investment which flows into the country. In other words, high interest rates attract more foreign investment and this increases the demand for a given currency and vice versa. Alternatively, inflation influences the exchange rates by changing the costs of production in a given economy, and therefore, changing the price of its exports. If it is very high, the inflation can inhibit the demand for the exports of the country, and this would depreciate its currency due to low demand. Lastly, the balance of payments influences the exchange rates through inflows and outflows of income in an economy, as explained prior.

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