Interest and Exchange Rates Influence on Multinational Corporations Essay

Interest and Exchange Rates Influence on Multinational Corporations - Essay Example Interest rates play an important part in investment and saving decisions. Interest rates are the main instrument of central banks to conduct their monetary policies. Interest rates have impact on foreign exchange rates. Higher relative interest rates (↑) attract higher financial investments in the short-run due to expectations for higher returns. The simplest way to explain this is to compare bank interest rates between two countries. If, in UK interest rates for deposits are 5%, compared to US deposit interest rates of 3%, then it will be economically sound for businesses to transfer their bank accounts to UK banks for higher returns. This, in turn will increase demand for UK currency, also increasing supply of US dollars. Increased demand will increase the value of the UK pound as compared to the US dollar, thus positively influencing the foreign exchange rate of the pound (↑). On the other hand, expectations for future changes also influence exchange rates. Higher interest rates (↑) have negative long-run effect on investment decisions of international businesses. Although higher interest rates attract more bank deposits, they are associated with unfavourable business situation and higher business risks for returns on investments; therefore they result in higher cost of capital (Barron’s, 1994, cited by Murphy, 1996). Since businesses worldwide are highly dependent on loan conditions, it is economically justified for businesses to invest in regions where business climate is securer, i.e. interest rates are lower.