This article highlights the key role played by the government by way of various monetary policies with regard to change in interest rates, and its resultant impact on the exchange rate of the country. While implementing the various monetary policies, it must be taken into consideration that the changes implemented today are likely to impact the economy in the long run, rather than right away, implying that there is a slight delay in time for the strategies to take effect. This entails the use of assumptions rather than facts, for deciding the monetary targets (Dickinson, 2002: 18). Furthermore, there is a strong relationship between inflation, interest rates and the exchange rate of any country. The same is highlighted and discussed in the following sections of this paper.
Exchange rate management plays a key role in the monetary policy framework of any country (Stone, 2009: 60). This is because the exchange rate of a country is one of the key determinants of its economic health, as it plays a key role in influencing the nation's international trade which is crucial for sustaining the economy. It is for this very reason the government keeps a watch on the exchange rate. Any increase in the currency rate has a direct impact on its exports, since the exports become costlier than before, while imports become cheaper and vice versa (Kirmani, Calika, 1994: 24).
According to Takatoshi (1996: 93) the real exchange rate is one of the fundamental factors in defining the rate of exchange between the domestic goods and the international goods. Thus, any change in the exchange rate triggers an economy-wide impact on the international trade. The impact and effectiveness of manipulating the exchange rate by government, as a measure of promoting international trade, and its simultaneous impact on ensuring the long term macro-economic stability of the country have been documented by various researchers over the years (Wikham, 1985; Frankel, 1996). Impact of interest rates on exchange rate: The article states that “Although the Reserve Bank of Australia is widely expected to hold the benchmark interest rate at 4.75% in May, the central bank may strike a hawkish tone for future policy as price pressures intensify, and the statement accompanying the rate decision could push the AUD/USD to a fresh record high as currency traders expect to see higher borrowing costs over the coming months”. There is a strong relationship between interest rates of a country and its exchange rate. Any increase in interest rates attracts foreign investment and hence an increase in capital, thus ultimately leading to a substantial rise in the exchange rate (Miles, Scott, 2005: 534-5). Figure: Impact of rise in interest rates on AUD: In the above figure, the relationship between increase in interest rate and exchange rate is shown with regard to the U.S. dollar rate. It can be seen that as there is an increase in interest rate, the rate of return on investments also increases which leads to an increase in the appreciation of the Australian Dollar. There is a strong relationship between interest rates, inflation as well as the exchange rate of the country. The government, through various central bank policies, manipulates the interest rates, leading to a change in the inflation as well as exchange rates. When the interest rates are changed i.e. either increased or decreased, the inflation and currency value of the country too changes simultaneously. An increase in interest rates affords higher returns to the lenders, as compared to the currencies of other countries. Thus, such a hike in interest rates attracts greater foreign capital in the form of investments,