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SHORT-RUN DETERMINANTS: INTEREST RATES AND EXCHANGE RATES

5 November, 2015 - 14:33

Money movements are, for the most part, triggered and channeled by the price one is willing to pay for the use of money or, alternatively, the benefit one is willing to accept for parting with it. This price is known as the interest rate. Thus, it follows that countries that are willing to offer a higher interest rate than the rest of the world will attract most of the available money. By the same token, countries whose interest rates are lowest will experience the greatest outflow of money.

Part c of Figure 8.1 shows that an increase in the interest rate of the United States will motivate the Germans to acquire stocks and bonds on the U.S. stock exchange. This German appetite for U.S. stocks and bonds will be translated into an increase in the supply of DMs within the United States, shown by the shift of the supply curve from S 1 to S2. Unfortunately for the Germans, Americans may not have a similar appetite for German stocks and bonds. If not, there will be a shift in the demand for deutsche marks from D 1 to D2. The result of these movements will be a drop in the value of the DM relative to the dollar. The DM will depreciate by some 20% .

In general, the following principles describe the short-term behavior of exchange rates:

  1. Currencies generally appreciate in countries whose inflation rates are lower than those in the rest of the world (for example, Japan and West Germany after 1986).
  2. Currencies generally depreciate in countries that experience lower economic activity than the rest of the world, because these countries import little (for example, the developing countries).
  3. Currencies generally appreciate in countries with higher interest rates, because these countries attract capital from the rest of the world (for example, the United States during the early 1980s).