International Finance Theory and Policy
by Steven M. Suranovic

Finance 20-4

The Effect of Changes in US Interest Rates on the Spot Exchange Rate

Suppose that the FOREX is initially in equilibrium such that S£ = D£ at the exchange rate E1. Now let average US interest rates, i$, rise. The increase in interest rates raises the rate of return on US assets, RoR$, which, at the original exchange rate causes the rate of return on US assets to exceed the rate of return on British assets, RoR$ > RoR£. This will raise the supply of £ on the FOREX as British investors seek the higher average return on US assets. It will also lower the demand for British £s by US investors who decide to invest at home rather than abroad. Thus in terms of the graph, S£ shifts right (black to red) while D£ shifts left (black to red). The equilibrium exchange rate falls to E2. This means that the increase in US interest rates cause a £ depreciation and a $ appreciation. As the exchange rate falls RoR£ rises since . RoR£ continues to rise until the interest parity condition, RoR$ = RoR£, again holds.

International Finance Theory and Policy - Chapter 20-4: Last Updated on 12/31/05