EECS 1710 Lecture 5: EECS 1710 Lecture 5 Notes
24 Jun 2018
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EECS 1710 Lecture 5 Notes
Introduction
Relative Interest Rates
In reality, the actual demand and supply schedules, and therefore the true equilibrium
exchange rate, will reflect several factors simultaneously.
The purpose of the preceding example is to demonstrate how the change in a single
factor (higher inflation) can affect an exchange rate.
Each factor can be assessed in isolation to determine its effect on exchange rates while
holding all other factors constant.
Then, all factors can be tied together to fully explain exchange rate movements.
Changes in relative interest rates affect investment in foreign securities, which
influences the demand for and supply of currencies and thus affects the equilibrium
exchange rate.
EXAMPLE
Assume that U.S. and British interest rates are initially equal but then U.S. interest rates
rise while British rates remain constant.
Then U.S. investors will likely reduce their demand for pounds, since U.S. rates are now
more attractive than British rates.
Because U.S. rates will now look more attractive to British investors with excess cash,
the supply of pounds for sale by British investors should increase as they establish more
bank deposits in the United States.
In response to this inward shift in the demand for pounds and outward shift in the
supply of pounds for sale, the equilibrium exchange rate should decrease.
These movements are represented graphically in Exhibit 4.6.
If U.S. interest rates decreased relative to British interest rates, then the opposite shifts
would be expected.
Document Summary
In reality, the actual demand and supply schedules, and therefore the true equilibrium exchange rate, will reflect several factors simultaneously. In response to this inward shift in the demand for pounds and outward shift in the supply of pounds for sale, the equilibrium exchange rate should decrease. These movements are represented graphically in exhibit 4. 6. If u. s. interest rates decreased relative to british interest rates, then the opposite shifts would be expected. To ensure that you understand these effects, predict the shifts in both the supply and demand curves for british pounds as well as the likely impact of these shifts on the pound"s value under the following scenario. The actual demand and supply schedules, and therefore the true equilibrium exchange rate, will reflect several factors simultaneously. The purpose of the preceding example is to demonstrate how the change in a single factor (higher inflation) can affect an exchange rate.
