Interest Rates an Exchange Rate - Essay Example

The government raised interest rates to increase the demand for pound in the international market, this increase in demand was anticipated to make the pound stronger against other major currencies, however a speculative attack by investors led to the loss of funds, the government lost and some investors gained huge profits on that day. This model depict that there is a relationship between the prevailing interest rates and the exchange rate, using historical data a country can use the data to estimate an appropriate model that will help in forecasting future values.

The model depicts that a rise in interest rate will lead to a rise in the value of the currency, when interest rates fall then the value of the currency declines, the following diagram shows the relationship between the two variables: From the above diagram it is evident that an increase in the interest rates will lead to an increase in the value of the currency, however a decline in interest rates will lead to a decline in the value of the currency. However the assumption of this model is that there are no speculative attacks and that the exchange rate depends on the demand and supply of the currency.

The relationship between the exchange rate and the interest rates can be demonstrated using two currencies from countries with different interest rates, we take hypothetical values and countries to demonstrate this and we choose country A and country B, for country a the interest rate is 4% and for country B the interest rate is 6%, those who have their funds deposited in country A will earn 4% for their investment, however it is more profitable to invest the funds or deposit the amount in country B due to high interest rates and therefore higher earning.

For this reason therefore investors will move their fund from country A to country B, investors from country A will exchange their money to get country B currencies, as a result of this the demand for country B currency will rise and therefore will the value of the currency. Therefore higher interest rates will encourage investors to invest in country B, if country B was to increase the interest rates from 5% to 10% then the higher will be the demand for their currency.British forecast:The exchange of the pound in 1992 was determined by the market demand and supply, in September the British government experienced a decline in the demand for their currency, many investors started selling the pound to acquire other currencies, as a result of this demand declined and therefore the pound lost value against other currencies.

The government had a role to play to resolve the crisis and this was done by increasing interests rates as described by the above model, the prevailing interest rates at the time was 10% and the government increased the interest rates to 12%, however despite this effort the investors still sold the pound to hold other currencies.Realizing this problem the government on the same day announced an increase in interest rates to 15%, this was the second attempt to resolve the problem, however it was unfortunate that investors kept on selling the pound and purchasing other currencies, as a result of this the value of the pound declined and this resulted into a decline in the value of the