Introduction - Interest Rate Transmission Mechanism

The Interest Rate Transmission Mechanism

The Impact of a Rise in Interest Rates on UK Sterling Exchange Rate

The interest rate influences the exchange rate because it influences the demand and supply of currencies on the foreign exchange markets. A good deal of the trade in foreign currencies is for speculative purposes - traders moving funds from one currency to another to take advantage of price movements or to take advantage of better returns in different countries.

For example, if the rate of interest in the US was 3% but was 5% in the UK, there may be advantages gained from transferring funds in dollar based securities to those denominated in Sterling. (Think of it in terms of moving money from a bank account paying 3% to another bank account paying a higher rate of interest.) If this happened, there would be a move towards selling dollars on the foreign exchanges and buying Sterling, with the result that the demand for Sterling would rise and the supply of dollars would also rise. This would put pressure on the price of Sterling and push its value up against the dollar.

The end result would be an appreciation of the pound meaning that it would be worth more in terms of dollars (e.g. rising from £1 = $1.60 to £1 = $1.70). This in turn means that the US buyer now has to give up more dollars to buy the same amount of Sterling, which is an effective rise in price for imports.

If the exchange rate rose from £1 = $1.60 to £1 = $1.70, how much would the US buyer now have to pay to purchase the good from the UK?
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No Flash plugin detected: The animation would depict the effect on the price of exports from the UK of a rise in the exchange rate between the pound and the dollar. The animation would depict the effect on the price of exports from the UK of a rise in the exchange rate between the pound and the dollar. A rise in the interest rate leads to an appreciation (rise) in the exchange rate from £1 = $1.60 to £1 = $1.70. The good priced at £5 in the UK now costs the US buyer $8.50 - a 50c rise in price.

We can conclude from this the following:

  • A rise in the interest rate will lead to a rise in the value of Sterling against other currencies (an appreciation).
  • A fall in the interest rate will lead to a fall in the value of Sterling against other currencies (a depreciation).

Other things being equal, an appreciation of the exchange rate will lead to:

  • A rise in export prices from the UK
  • A fall in import prices to the UK

This in turn would be expected to have an effect on the demand for both imports and exports. We would expect:

  • The demand for exports to fall as export prices rise
  • The demand for imports to rise as import prices fall

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