What is the Effect of interest Rates on Exchange Rates?

Int Rates are Different in each countries

So Investors move from countries having lower interest rate to countries having higher interest rates

This leads to appreciation of currency of country having higher interest rates

Example

Suppose there are 2 Countries A and B

Both countries issue Govt Bonds

Interest Rate on Govt Bonds is 8% in A and 10% in B

Hence, there is Interest Rate Differential of 2%

B Country's Investors will prefer to invest in their own country rather than in Country A

Also Investors in Country A will prefer to invest in Country B

So they will purchase foreign currency of B Country

Hence, there will be more demand for B's currency and hence B Country currency will appreciate

Assumption

There is no restriction of buying bonds of foreign governments