The interest rate differential plays a crucial role in influencing exchange rates by attracting investments to the currency that offers higher returns.

The term “interest rate differential” refers to the disparity in interest rates between two countries. This difference is significant in determining the exchange rate of their respective currencies. The underlying principle is that investors seek the highest returns on their investments. Consequently, when one country offers a higher interest rate than another, it tends to attract more foreign capital, as investors relocate their assets to capitalize on the better returns. This increased demand for the currency of the country with the higher interest rate results in an appreciation of its exchange rate.

For instance, consider a scenario where the United Kingdom has an interest rate of $2\%$ and the United States has an interest rate of $1\%$. In this case, investors are likely to transfer their assets to the UK to take advantage of the higher interest rate. This shift would increase the demand for the British pound, leading to its appreciation against the US dollar. Conversely, if the US were to raise its interest rates above those of the UK, the flow of capital would reverse, resulting in a depreciation of the pound against the dollar.

However, it is essential to recognize that this explanation is somewhat simplified. In practice, exchange rates are affected by a myriad of factors, including inflation rates, political stability, economic performance, and market speculation. Additionally, high-interest rates may also signal potential inflation risks or a weak economy, which could deter investors.

Moreover, the effects of interest rate differentials can be further influenced by market expectations. If investors anticipate that interest rates in a particular country will rise in the future, they may begin purchasing that country’s currency ahead of time, leading to its appreciation. This phenomenon is referred to as ‘speculative demand’.

In conclusion, while the interest rate differential is a fundamental factor in determining exchange rates, it represents only one aspect of a multifaceted system. Grasping this concept is vital for anyone studying international economics, as it provides valuable insights into the dynamics of foreign exchange markets and international investment flows.