Financial Markets and Institutions (2-downloads)

the domestic currency appreciates.

When the nominal interest rate rises because of an increase in expected infla-

tion, we get a different result from the one shown in Figure 15.4. The rise in

expected domestic inflation leads to a decline in the expected appreciation of the

p

e

i

⫽ i

r

⫹ p

e

---

Chapter 15 The Foreign Exchange Market

361

dollar, which is typically thought to be larger than the increase in the domestic inter-

est rate i

D

.

1

As a result, at any given exchange rate, the relative expected return

on domestic (dollar) assets falls, the demand curve shifts to the left, and the

exchange rate falls from E

1

to E

2

as shown in Figure 15.7. Our analysis leads to

this conclusion: When domestic interest rates rise due to an expected