Demand and Supply Shifts in Foreign Exchange Markets

Differences across Countries in Rates of Return

The motivation for investment, whether domestic or foreign, is to earn a return. If rates of return in a country look relatively high, then that country will tend to attract funds from abroad. Conversely, if rates of return in a country look relatively low, then funds will tend to flee to other economies. Changes in the expected rate of return will shift demand and supply for a currency. For example, imagine that interest rates rise in the United States as compared with Mexico. Thus, financial investments in the United States promise a higher return than previously. As a result, more investors will demand U.S. dollars so that they can buy interest-bearing assets and fewer investors will be willing to supply U.S. dollars to foreign exchange markets. Demand for the U.S. dollar will shift to the right, from D0 to D1, and supply will shift to the left, from S0 to S1, as Figure shows. The new equilibrium (E1), will occur at an exchange rate of nine pesos/dollar and the same quantity of $8.5 billion. Thus, a higher interest rate or rate of return relative to other countries leads a nation’s currency to appreciate or strengthen, and a lower interest rate relative to other countries leads a nation’s currency to depreciate or weaken. Since a nation’s central bank can use monetary policy to affect its interest rates, a central bank can also cause changes in exchange rates—a connection that we will discuss in more detail later in this chapter.

The graph shows how supply and demand would change if the U.S. dollar brought a higher rate of return.
Exchange Rate Market for U.S. Dollars Reacts to Higher Interest Rates A higher rate of return for U.S. dollars makes holding dollars more attractive. Thus, the demand for dollars in the foreign exchange market shifts to the right, from D0 to D1, while the supply of dollars shifts to the left, from S0 to S1. The new equilibrium (E1) has a stronger exchange rate than the original equilibrium (E0), but in this example, the equilibrium quantity traded does not change.