Interest Rate Differential theory claims that exchange rate movements are determined by a nation's interest rate level.

According to the theory,

• Countries with higher interest rates should experience their currency appreciate in value.


• Countries with lower interest rates should experience their currency depreciate in value.

When a country raises its interest rates, it's currency become more attractive to domestic and foreign investors so investment dollar will flock to that country due to higher yield for that country's currency.

Limitations of Model

This theory heavily relies on capital flows discounting a nation's current account balance.

Moreover, the model assumes numerous factors in check such as: political stability, inflation, economic growth, and various others.

Give a shout for the interest rate differential theory.