How interest rate affects currency?

Question

I am quite new to economics. I was reading about changes in interest rates and its effect on currency value. The fact is as interest rates increases, the currency value also increases and vice versa. However I want to understand the reason.At first, I thought following: As interest rate increase, people borrow less, spend less, so cost of goods decreases, value of currency increases.However when I read in investopedia, it says following:> Generally, higher interest rates increase the value of a given country's currency. The higher interest rates that can be earned tend to attract foreign investment, increasing the demand for and value of the home country's currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative value.**Q1.** Now I dont understand what does it mean by ***increasing the demand for and value of the home country's currency***. What is it meant by demand for currency by foreign investors?In [another article](http://www.investopedia.com/ask/answers/040315/how-do-changes-national-interest-rates-affect-currencys-value-and-exchange-rate.asp) it says:> The rise of interest rates in a country often spurs inflation, and higher inflation tends to decrease the value of a currency. But on the same page, it says:> Generally, higher interest rates increase the value of a given country's currency. **Q2.** Why these two different statements are there?If I understand it correct, the word "spurs" here means increases inflation. But this confuses me.My understanding is: - interest rate increases, people can borrow less, spend less, economy slows, inflation decreases, currency value increases - interest rate decreases, people borrow more, spend more, economy grow, inflation increases, currency value decreases**Q3.** Are these understanding correct in general (though I understand the relation is not that straight forward and there are other factors too that affects currency value / inflation)?

Answer 1

I suggest that you study the Mundell-Fleming model for a small economy (such as Canada) and the Short-run model of the large open economy (such as the US). They are explained in Intermediate Macroeconomics textbooks.

The last model explains the interrelationship between the variables that you mention. For example, if there is a fiscal expansion (more government expenses), interest rates go up, GDP goes up and the Net Capital Outflow decreases. As the Net Capital Outflow decreases, Net Exports decreases and the Exchange Rate increases.

These relationships are better seen with the three graphs used by the model.

The US trade deficit has been reduced slightly during this year. Consequently, the exchange rate has increased and the dollar is “stronger”.

Rod