Currency prices are what the market is all about, but interest rates have a direct effect on those prices. Therefore, to be able to understand the current foreign exchange market you have to understand the current conditions of each individual interest rate. While economic and political conditions are also among the things that greatly affect the forex market there is nothing that affects it more than interest rates.
When the interest rate of a country raises the demand of that country’s currency goes up and its value gets appreciated and vice versa. When the interest rates raise investors will want to capitalize high returns and you will see money flowing into the country. When one country’s interest rates rise their currency is seen as being stronger than other currencies. This happens because investors seek more of that currency to profit more.
Interest rates can be simply defined as the amount of money a borrower must pay to a lender in order to hold their money. In a simple representation of the foreign exchange market the lender is an investor holding cash or assets and the borrower is a bank inside a particular country. The lender (investor) provides money to the borrower (the bank) and after a specific time period will receive interest in conjunction with the original sum which was put in.
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.
Forex traders should always take a look at the full picture. Why the interest rates are raised or lowered. How is the country doing economically? Most important you need to know about the country that you're pairing the high interest currency against. This is all a game of relation. Sometimes it's one of the currencies in the pair that is causing movement and sometimes it's both, so it's always good to take the full picture into account.