Exchange Rate Effects of Changes in Foreign 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'_$/£. The initial equilibrium is depicted in the adjoining diagram. Next suppose British interest rates rise, ceteris paribus. Ceteris paribus means we assume all other exogenous variables remain fixed at their original values. In this model the US interest rate, i_$, and the expected exchange rate, E^e_$/£, both remain fixed as British interest rates rise.

The increase in British interest rates, i_£, will shift the British RoR line to the right from RoR'_£ to RoR"_£ as indicted by step 1.

The reason for the shift can be seen by looking at the simple rate of return formula.

Suppose one is at the original equilibrium with exchange rate E'_$/£. Looking at the formula, an increase in i£ clearly raises the value of RoR_£ for any fixed values of E^e_$/£. This could be represented as a shift to the right on the diagram, as from A to B. Once at B with a new interest rate, one could perform the exercise used to plot out the downward sloping RoR curve. (see 20-7). The result would be a curve, like the original, but shifted entirely to the right.

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

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

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

International Finance Theory and Policy - Chapter 20-10: Last Updated on 2/19/05