Fundamental Indicator

The Real Interest Rate Differentials Model indicates that movements in the price of currencies are determined by the levels of interest rates of the countries. Thus, the currencies of countries with high-interest rates should grow in value while the opposite should happen with nations whose interest rates are low.

As we will see below, this model is not able to explain all the movements in the currency market, although much of what happens in the Forex (and in other financial markets) is related directly and indirectly to interest rates.

Bases of the Model

Whenever a country raises its interest rates, international investors discover that the currency of that nation has a higher yield and therefore these investors start buying the currency. This theory was very successful in 2003 when the spreads of interest rates were quite close to the highest levels of the past years.

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We can define inflation as the general increase in prices of goods and services in connection with a currency at a specific time period. When the price of these resources increases, the purchasing power of the country’s monetary unit drops so the people of the country can buy fewer goods and services and this has an overall impact on the economy. In other words, this means that inflation causes the purchasing power of a currency to decline.

Inflation has a negative effect on all members of society regardless of their socioeconomic level, and obviously, it affects all consumers in the economy of a country, for this reason, is one of the most important economic indicators for Central Banks and investors of financial markets such as Forex. 

Many economists believe that inflation can be positive if it has a moderate level. Meanwhile, central banks invest huge efforts to keep inflation within well-established limits, so that the economy of the country can take advantage of the positive aspects of inflation while at the same time the negative effects of it are minimized.

One of the main measures implemented to counter the inflationary pressure is rising interest rates. When interest rates rise, commercial banks proceed to increase the interest of the loans they make to their customers.

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Definition of currency wars

It consists of manipulating the currency to sell more. You lower the value of your country’s currency and artificially lower your products to make them more attractive in other countries and increase your exports.

How can a country manipulate its currency? There are many ways, but simplifying, the two main ones would be:

1. Lower interest rates. You pay less to have the coin. People prefer to invest in other currencies with higher interest rates.
2. Sell a lot of your currency in exchange for other foreign currencies. In this way, you flood the market with yen, for example, and that depreciates the currency.

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