Financial Markets and Institutions (2-downloads)

i

D

shifts the demand curve for domestic assets, D, to the right and causes

the domestic currency to appreciate

(E

).

Conversely, if i

D

falls, the relative expected return on dollar assets falls, the

demand curve shifts to the left, and the exchange rate falls. A decrease in the

domestic interest rate i

D

shifts the demand curve for domestic assets, D,

to the left and causes the domestic currency to depreciate

(E ).

Foreign Interest Rate, 

i

F

Suppose that the foreign asset pays an interest rate of

i

F

. When the foreign interest rate i

F

rises, holding the current exchange rate and

everything else constant, the return on foreign assets rises relative to dollar assets.

Thus the relative expected return on dollar assets falls. Now people want to hold

fewer dollar assets, and the quantity demanded decreases at every value of the

exchange rate. This scenario is shown by the leftward shift of the demand curve in

Figure 15.5 from D

1

to D

2

. The new equilibrium is reached at point 2, when the value

of the dollar has fallen. Conversely, a decrease in i

F

raises the relative expected return

on dollar assets, shifts the demand curve to the right, and raises the exchange rate.

T

c

Access

http://fx.sauder

.ubc.ca

. The Pacific

Exchange Rate Service at

the University of British

Columbia’s Sauder School

of Business provides

information on how market

conditions are affecting

exchange rates and allows

easy plotting of exchange

rate data.

G O   O N L I N E

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356

Part 5 Financial Markets

S

Exchange Rate, E

t

(euros/$)

Quantity of Dollar Assets

E

1

E

2

D

1

D

2