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