Interest rates and their impact on exchange rates

Let's talk about interest rates and how they affect the foreign exchange market by the example of the banking system in the U.S., since I am a resident of this country.

As required by the U.S. Federal Reserve, every U.S. bank must have a certain amount of cash reserves. These funds are intended for operations with customers.

If at any time customers want to get their hands on deposits, and the bank is not there for that purpose, that we may see another banking crisis. That's why the Fed raises specific requirements for the amount of reserve funds.

Daily banks make a lot of transactions, and each bank is interested in increasing the volume of its operations for the greater benefit (on commission, etc.). There are times when someone unexpectedly asks the customer of the bank to withdraw a large sum of money. In this case, the amount of reserves banks are cutting and does not meet the requirements of the Federal Reserve, which in the long run, such a bank could spell some problems.

Fed discount rate - is the percentage by which the U.S. central bank lends to commercial banks. Thanks to the Federal Reserve banks to increase lending capacity reserves to meet the requirements of the very same Fed.

Usually commercial banks borrow from each other, but if a bank wants to get a loan, does not find funds from his "colleagues", then comes to the rescue of the U.S. Federal Reserve. However, the U.S. central bank issued a loan to return the next day. Furthermore, the U.S. Federal Reserve does not welcome such behavior of banks, and if it becomes too frequent, banks' reserve requirements could be tightened.

Can not assume that the Fed just makes loans to commercial banks to lend to people (!). This approach is wrong and is often caused by an erroneous view of the functioning of banks and discredits the banking system. Therefore, should be given the necessary attention to the banking system.

Thus, the importance of the interest rate the Fed is that it is on this basis calculated all other interest rates in the country. Meanwhile, the Fed loans to commercial banks - are loans associated with the lowest risk. The fact that they are available only for one night and get only financial institutions with excellent credit history. Furthermore, depending on the type of loan, to the size of the discount rate charged different premiums - in accordance with the terms and conditions of the credit.
It was to be the case with lending banks. Answering the question why the level of the interest rate the Fed is so important, you need to understand about what the securities in question. If we talk about the stock markets, the high interest rates lead to an increase in the cost of capital of the company - that is, for companies whose shares are traded on the stock exchanges, it is bad. A bond picture is reversed, as reduce the risk of high rates of inflation.

In the currency market, the situation is more complicated, the interest rate affects the rate of exchange on several levels. Sure, there is the swap rate at which a foreign exchange transaction. But this is only a small part of the equation. Global financial flows, which account for most of the volume of transactions in the foreign exchange market - the movement of capital, due to investors looking for more value from the investment. Depending on the state of the stock market, bonds and real estate, as well as the rate of inflation in each country to raise interest rates may affect the profitability of investment in both a positive and a negative side.

For a more detailed study of the topic of influence of interest rates on currency suggest reading the book John Percival - The Way of The Dollar.