How do interest rates influence currency values?

Interest rates have a significant influence on currency values, primarily because they affect the return on investments in a given currency. When a country offers higher interest rates, it becomes more attractive to global investors who are searching for better yields on their investments. This influx of capital occurs as investors convert their foreign currency into the currency of the high-interest-rate country to purchase bonds or other interest-bearing assets.

As demand for the higher-yielding currency increases, its value relative to other currencies typically rises. This relationship illustrates the direct correlation between interest rates and currency strength. Higher bond yields attract foreign investment, leading to increased demand for the currency, which subsequently strengthens it in the foreign exchange market.

Consequently, while other options may address aspects of economic activity or investment behavior, they do not accurately capture the fundamental mechanism of how higher interest rates enhance the attractiveness of a currency through increased foreign capital inflow and demand.