Finance - International Business

How Changes in Exchange Rates and Interest Rates Affect Costs and Prices of Firms Operating in International Markets?

What Effect These Changes Might Have On A Multinational Corporation Decision To Invest Globally?

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How Changes in Exchange Rates and Interest Rates Affect Costs and Prices of Firms Operating in International Markets?

What Effect These Changes Might Have On A Multinational Corporation Decision To Invest Globally?

Abstract

Changes in interest and exchange rates directly affect profitability of companies having international business by influencing their investment decisions, production costs and prices. High interest rates are associated with higher business risk and make cost of capital more expensive, thus reducing profitability and amount of business investments in the region over a long-run period. On the other hand high interest rates are positively related to short-term exchange rates due to increased demand of the national currency. This results in higher prices of exported products and services, followed by decrease in exports, and increase in imports.

BusinessesЃf investment decisions for international markets are thus influenced not only by current interest and exchange rates, but also by expectations for future developments.

The purpose of this analysis is to give a justified explanation of the effect of those changes.

Currency exchange rates

The driving force of international currency exchange markets are businesses, people and financial institutions that either speculate with exchange rates or are involved in international commerce.

The exchange rate is the price of one countryЃfs currency in terms of another countryЃfs currency (Ross, A. et al, (year?)). Few countries fix the exchange value of their currency to other key currency such as US dollar or the euro. The exchange rate between most currencies is usually determined by market forces of supply and demand. When for example the UK pound ЃgstrengthensЃh or ЃgappreciatesЃh, this means that the value of the UK pound rises, so it takes more foreign currency to buy one pound.

Basically, increased demand for one currency positively impacts the value of this currency on the foreign exchange market.

Higher exchange rate of UK pound versus US dollar means that goods and services imported by UK into the US market will be more expensive, i.e. prices of UK products will be higher (ЃЄ). UK businesses operating on the US market will sell at higher prices, oppositely, US goods and services imported into the UK will be cheaper. Thus UK products will face decreasing demand abroad and exports will diminish, while UK import from the USA will increase due to lower prices. The result will be decrease in output for companies with international sales.

Interest rates

Interest rates play an important part in business and individual 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 (ЃЄ) 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 (ЃЄ).

On the other hand, expectations for future changes also influence exchange rates. Higher interest rates (ЃЄ) 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 (BarronЃfs, 1994). Since businesses worldwide are highly dependent on loan conditions,