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

International Finance Theory and Policy - Chapter 20-5: Last Updated on 12/2/05