Financial Markets and Institutions (2-downloads)

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To summarize, an increase in the foreign interest rate i

F

shifts the demand

curve D to the left and causes the domestic currency to depreciate; a fall

in the foreign interest rate i

F

shifts the demand curve D to the right and

causes the domestic currency to appreciate.

Changes in the Expected Future Exchange Rate, 

Expectations about the

future value of the exchange rate play an important role in shifting the current

demand curve because the demand for domestic assets, like the demand for any

durable good, depends on the future resale price. Any factor that causes the expected

future exchange rate, 

, to rise increases the expected appreciation of the dol-

lar. The result is a higher relative expected return on dollar assets, which increases

the demand for dollar assets at every exchange rate, thereby shifting the demand

curve to the right in Figure 15.6 from D

1

to D

2

. The equilibrium exchange rate rises

to point 2 at the intersection of the D

2

and S curves. A rise in the expected future

exchange rate,

, shifts the demand curve to the right and causes an