EECS 1710 Lecture 6: EECS 1710 Lecture 6 Notes
24 Jun 2018
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EECS 1710 Lecture 6 Notes
Introduction
Real Interest Rates
Assume that U.S. and British interest rates are initially equal but then British interest
rates rise while U.S. rates remain constant.
Then British interest rates may become more attractive to U.S. investors with excess
cash, which would cause the demand for British pounds to increase.
At the same time, the U.S. interest rates should look less attractive to British investors
and so the British supply of pounds for sale would decrease.
Given this outward shift in the demand for pounds and inward shift in the supply of
pounds for sale, the pound’s equilibrium exchange rate should increase.
Although a relatively high interest rate may attract foreign inflows (to invest in securities
offering high yields), that high rate may reflect expectations of relatively high inflation.
Because high inflation can place downward pressure on the local currency, some foreign
investors may be discouraged from investing in securities denominated in that currency.
In such cases it is useful to consider the real interest rate, which adjusts the nominal
interest rate for inflation
Real interest rate ¼ Nominal interest rate Inflation rate
This relationship is sometimes called the Fisher effect.
The real interest rate is appropriate for international comparisons of exchange rate
movements because it incorporates both the nominal interest rate and inflation, each of
which influences exchange rates.
Other things held constant, a high U.S. real rate of interest (relative to other countries)
tends to boost the dollar’s value.
Relative Income Levels
A third factor affecting exchange rates is relative income levels.
