Lesson 2: What Makes Interest Rates in Forex Interesting?

Interest rates are one of the economic factors that traders pay the most attention to. They are among the key indicators of whether investors will find a country attractive for investments. 

In this regard, interest rates are a major deciding factor in how valuable a country’s currency will be in the financial market. 

This lesson will help you gain a deeper understanding of interest rates and how they can affect your trades. 

Lesson Highlights 

• Interest rates represent the amount of money a lender receives for letting other people or institutions use their funds. 
• Central banks typically control the interest rates of their respective countries. 
• A country’s central bank can tweak its interest rates depending on the country’s needs. 
• Central banks use economic indicators to determine how they will change their countries’ interest rates. 
• Central banks can use interest rates to control the volume of local currencies in circulation. 
• There are two primary types of interest rates: nominal and real interest rates. 

What Are Interest Rates?

Interest rates refer to how much borrowing money would cost you; the interest rate represents the return on investments for the money you borrowed or deposited. 

A country’s interest rates affect how likely foreign investors are to invest in a particular country. Countries with higher interest rates tend to attract more foreign investments. In contrast, countries with low interest rates have fewer investments coming their way. 

Interest rates help keep a country’s economy stable and its market liquid. 

Countries’ monetary policymakers use interest rates to control their country’s circulating money supply. Higher interest rates encourage people to save more and reduce borrowing from central banks. When interest rates are low, people tend to borrow and spend more, helping fuel the economy. 

Types of Interest Rates 

There are two primary types of interest rates: nominal and real.  

1. Nominal Interest Rate 

The nominal interest rate refers to the rate you pay or receive for your moneylending transactions. It’s the amount explicitly stated in contracts, without considering adjustments for inflation or other additional costs. 

Suppose you borrow $1,000 from a bank with a 10% nominal interest rate. This doesn’t mean that you’ll have to pay the bank back $1,100. Instead, you must still consider other factors, such as transaction fees and inflation rate, into the equation. 

This means that the nominal interest rate is never the actual interest cost but a basis for calculating it. 

2. Real Interest Rate 

The real interest rate reflects the true value of the interest you’ll pay or receive. It accounts for the calculation of interest rates after including adjustments for inflation rate and other additional costs. 

To calculate the real interest rate, simply subtract the inflation rate from the nominal interest rate. 

For example, if a bank lent you money with a 10% nominal interest rate, and the current inflation rate is at 5%, then the real interest rate would only be 5%. 

Who Controls a Country’s Interest Rates? 

Typically, a country’s central bank controls its interest rates. These banks wield monetary policy tools and the authority to adjust their respective countries’ interest rates if they see fit. 

The table below shows some of the world’s major economies and their central banks. 

How Do Central Banks Determine Interest Rates? 

Central banks generally rely on economic indicators to determine how they will modify their countries’ interest rates.  

These economic indicators can include: 

• Consumer Price Index (CPI) 
• Producer Price Index (PPI) 
• Employment levels 
• Inflation rate 

How Do Interest Rates Affect Your Trades? 

Interest rates affect a country’s economic growth, which, in turn, affects the value of that country’s currency. As currencies are always traded in pairs, one currency gaining strength means the other is weakening (against it).