Interest rates and their impact on exchange rates
Let's talk about interest rates and how they affect the foreign exchange market as an example of the banking system in the United States. In accordance with the requirements of U.S. Federal Reserve, every U.S. bank must have a certain amount of cash reserves. These funds are intended for operations with customers.
If at any time customers want to get their deposits on hand, and the bank is not there for that purpose, we may be witnessing the next banking crisis. That is why the Fed puts specific requirements on the size of the reserve.
Every day, banks carry a huge number of transactions, and each bank is interested in increasing the volume of its operations for the greater benefit (in commissions, etc.). There are times when someone unexpectedly asks the customer of the bank to withdraw a large sum of money. In this case, the volume of bank reserves and reduces the Fed does not meet that, ultimately, such a bank could spell a number of problems.
Fed's discount rate - is the percentage by which the U.S. central bank lends to commercial banks. Thanks to the Fed's loans to the banks increase the amount of reserves to meet the requirements of the very same Fed.
Generally, commercial banks borrow from each other, but if a bank wishes to obtain credit, money is not from their "colleagues", then comes to the rescue of the U.S. Federal Reserve. However, the U.S. central bank issued a loan to be returned the next day. Moreover, the U.S. Federal Reserve does not approve of such behavior of banks, and if it becomes too frequent, banks' reserve requirements could be tightened.
Do not assume that just gives the Fed loans to commercial banks for lending to households (!). Such an approach is wrong and is often caused by an erroneous view of the functioning of banks, and discredits the banking system. Therefore, should be given the necessary attention to the banking system. Thus, the importance of the discount rate the Fed is that it is calculated on this basis all the other interest rates in the country. Meanwhile, the Fed loans to commercial banks - are loans associated with the lowest risk. The fact that they are provided only for one night and get only financial institutions with excellent credit history. Then, depending on the type of loan to the size of the discount rate charged different premiums - in accordance with the terms and conditions of lending.
This is how things stand with lending banks. Answering the question why the level of interest rates the Fed is so important, you must understand about any securities in question. If we talk about stock markets, high interest rates lead to an increase in the cost of capital - that is, for companies whose shares are traded on exchanges, it is not good. A bond picture is reversed, since high interest rates reduce the risk of inflation.
In the currency market, the situation is more complicated, the interest rate affects the rates at several levels. Sure, there is a swap rate at which foreign exchange transactions take place. But this is only a small part of the equation. Global financial flows, which account for most of the volume of transactions in the currency market - the movement of capital due to investors seeking higher gains on investments. Depending on the condition of the stock market, bonds and real estate, as well as the rate of inflation in each country to raise interest rates may affect the profitability of investment in both the positive and the negative side.