Exchange Rate Effects of Changes in US Interest Rates using a RoR Diagram

Suppose that the FOREX is initially in equilibrium such that RoR_£ = RoR_$ (i.e., interest rate parity holds) at an initial equilibrium exchange rate given by E'_$/£. The initial equilibrium is depicted in the adjoining diagram. Next suppose US interest rates rise, ceteris paribus. Ceteris paribus means we assume all other exogenous variables remain fixed at their original values. In this model the British interest rate, i_£, and the expected exchange rate, E^e_$/£, both remain fixed as US interest rates rise.

The increase in US interest rates will shift the US RoR line to the right from RoR'_$ to RoR"_$ as indicted by step 1. Immediately after the increase, before the exchange rate changes, RoR_$ > RoR_£. The adjustment to the new equilibrium will follow the "exchange rate too high" equilibrium story presented in 20-8. Accordingly, higher US interest rates will make US $ investments more attractive to investors leading to an increase in demand for $ on the FOREX, resulting in an appreciation of the dollar, a depreciation of the pound and a decrease in E_$/£. The exchange rate will fall to the new equilibrium rate E"_$/£ as indicted by step 2.

In brief: An increase in the US interest rate will raise the rate of return on dollars above the rate of return on pounds, lead investors to shift investments to US assets, and result in a decrease in the $/£ exchange rate (i.e., an appreciation of the US dollar and a depreciation of the British pound).

In reverse: A decrease in US interest rates will lower the rate of return on dollars below the rate of return on pounds, lead investors to shift investments to British assets, and result in an increase in the $/£ exchange rate (i.e., a depreciation of the US dollar and an appreciation of the British pound).

International Finance Theory and Policy - Chapter 20-9: Last Updated on 2/19/05