By what mechanism do interest rates affect currency values?

Interest rates significantly influence currency values primarily through their impact on investment and capital flows. When interest rates rise in a particular country, they often lead to higher yields on that country's bonds and other fixed-income investments. This attraction draws global investors seeking better returns on their investments. As these investors convert their foreign currency into the local currency to purchase these higher-yielding assets, the demand for the local currency increases, thereby strengthening its value relative to other currencies.

This mechanism highlights the interplay between interest rates and investor behavior, emphasizing the importance of returns on investments in driving demand for currencies. High bond yields typically indicate a robust economic environment or signal that the central bank may be taking measures to control inflation, further enhancing the appeal of the country's assets and its currency. Understanding this relationship is crucial for analyzing market dynamics and forecasting currency movements.

The other choices might relate to interest rates and economic indicators, but they do not capture the primary mechanism by which interest rates directly impact currency values as effectively as the attraction of higher bond yields does.