Interest rates refer to the extra money a borrower must pay above the principal amount of a debt. Interest rates function on multiple levels, as individuals pay interest on money they borrow from banks and banks pay interest on money they borrow from investors and each other, and governments pay interest on the money they borrow from banks and the public. In forex, the interest rates that matter most to traders are the rates that a central bank demands from commercial banks. The rate set by central banks will influence every other rate being offered across the economy.
When it comes to forex, interest rates are important as a monetary policy tool. A country can spur or slow the economy by tightening (raising interest rates) or loosening (lowering interest rates) credit. Central banks often set inflation targets in order to encourage economic growth and then they realize these targets by adjusting interest rates. For this reason, forex traders watch interest rates to see how they will impact the underlying economy and currency. Simply put, interest rates are a fundamental driver of price action in the currency market.
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