What typically occurs when a central bank unexpectedly increases interest rates?

When a central bank unexpectedly increases interest rates, the value of the currency typically strengthens. This occurs because higher interest rates offer better returns on investments denominated in that currency, attracting foreign capital inflows. Investors seeking higher yields will buy assets in that currency, increasing demand for it and consequently driving up its value in the foreign exchange market.

Additionally, higher interest rates can lead to tighter monetary policy, which signals to the market that the central bank is committed to controlling inflation. This further enhances investor confidence in the stability and soundness of the economy associated with that currency. The combination of increased demand from foreign investors and a perception of a stable monetary environment contributes to a stronger currency.

In contrast, other scenarios like the currency weakening may occur in different contexts, such as when monetary policy is perceived as overly aggressive or detrimental to growth, but those situations diverge from the expected outcome resulting specifically from an unexpected rate hike.