Finance 204

Suppose
that the FOREX is initially in equilibrium such that S_{£}
= D_{£} at the exchange rate E^{1}.
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 E^{2}.
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.
