Deposit Rate Liberalization and Exchange Rate Reforms

In an open economy, exchange rate and interest rates influence and restrain each other and affect the internal and external equilibria of the economy. Interest rates influence exchange rate in direct and indirect ways. Under the direct effect, the flow of international arbitrage capital induces exchange rate variations. With other conditions being constant, when interest rate in a home country is above the international level, short-term capital will flow into the home country, whose currency appreciates as demand for its currency increases in the foreign exchange market. Otherwise, there will be a capital outflow, causing its currency to depreciate. Under the indirect effect, interest rates influence the exchange rate level by altering domestic aggregate demand.