Exchange Rates

 We often read in the newspaper that the dollar is strong because U.S. interest rates are high or that it is falling because U.S. interest rates are falling. Can these statements be explained using our analysis of the foreign exchange market? To answer this question, we again turn to a diagram. Figure 14-5 shows a rise in the interest rate on dollars, from R 1 to R 2 + + as a rightward shift of the vertical dollar deposits return schedule. At the initial exchange rate E 1 + > : , the expected return on dollar deposits is now higher than that on euro deposits by an amount equal to the distance between points 1 and 1 ′ . As we have seen, this difference causes the dollar to appreciate to E 2 + > : (point 2). Because there has been no change in the euro interest rate or in the expected future exchange rate, the dollar’s appreciation today raises the expected dollar return on euro deposits by increasing the rate at which the dollar is expected to depreciate in the future. Figure 14-6 shows the effect of a rise in the euro interest rate R : . This change causes the downward-sloping schedule (which measures the expected dollar return on euro deposits) to shift rightward. (To see why, ask yourself how a rise in the euro interest rate alters the dollar return on euro deposits, given the current exchange rate and the expected future rate.) At the initial exchange rate E 1 + > : , the expected depreciation rate of the dollar is the same as before the rise in R : , so the expected return on euro deposits now exceeds that on dollar deposits. The dollar/euro exchange rate rises (from E 1 2 + > : to E + > : ) to eliminate the excess supply of dollar assets at point 1. As before, the dollar’s depreciation against the euro eliminates the excess supply of dollar assets by lowering the expected dollar

rate of return on euro deposits. A rise in European interest rates therefore leads to a depreciation of the dollar against the euro or, looked at from the European perspective, an appreciation of the euro against the dollar. Our discussion shows that, all else equal, an increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currencies . Before we conclude that the newspaper account of the effect of interest rates on exchange rates is correct, we must remember that our assumption of a constant expected future exchange rate often is unrealistic. In many cases, a change in interest rates will be accompanied by a change in the expected future exchange rate. This change in the expected future exchange rate will depend, in turn, on the economic causes of the interest rate change. We compare different possible relationships between interest rates and expected future exchange rates in Chapter 16. Keep in mind for now that in the real world, we cannot predict how a given interest rate change will alter exchange rates unless we know why the interest rate is changing. The Effect of Changing Expectations on the Current Exchange Rate Figure 14-6 may also be used to study the effect on today’s exchange rate of a rise in the expected future dollar/euro exchange rate, E e + > : . Given today’s exchange rate, a rise in the expected future price of euros in terms of dollars raises the dollar’s expected depreciation rate. For example, if today’s exchange rate is $1.00 per euro and the rate expected to prevail in a year is $1.05 per euro, the expected depreciation rate of the dollar against the euro is (1.05 - 1.00) > 1.00 = 0.05; if the expected future exchange rate now rises to $1.06 per euro, the expected depreciation rate also rises, to (1.06 - 1.00) > 1.00 = 0.06. Because a rise in the expected depreciation rate of the dollar raises the expected dollar return on euro deposits, the downward-sloping schedule shifts to the right, as in Figure 14-6. At the initial exchange rate E 1 + > : , there is now an excess supply of dollar deposits: Euro deposits offer a higher expected rate of return (measured in dollar terms) than do dollar deposits. The dollar therefore depreciates against the euro until equilibrium is reached at point 2. We conclude that, all else equal, a rise in the expected future exchange rate causes a rise in the current exchange rate. Similarly, a fall in the expected future exchange rate causes a fall in the current exchange rate.

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