The Economics of Foreign Exchange: Real Interest Rates in the United States

Real Interest Rates in the United States The willingness of foreigners to hold dollar assets in the United States depends on the interest rates that can be earned on assets denominated in dollars. The higher U.S. real interest rates are relative to real interest rates in foreign nations, the greater the demand by foreigners to hold dollar financial assets and, other things being equal, the higher the exchange rate of the dollar. High real interest rates in the United States in the early 1980s contributed to strong demand by foreigners for dollars and caused the exchange rate of the dollar to soar. As U.S. interest rates fell relative to those in foreign nations in 1985 and 1986, the exchange rate of the dollar against such key currencies as the mark and the yen began to plummet. Note that these changes in the demand for dollars can be caused either by a change in U.S. real interest rates or by changes in foreign real interest rates. Higher real interest rates in the United States relative to those in foreign nations will decrease the supply of dollars offered on foreign exchange markets, because U.S. investors will be less interested in selling dollars to make loans and buy securities of foreign governments and businesses. This will also tend to put upward pressure on the exchange rate as the supply curve of dollars shifts to the left. Profitability of Direct Investment in U.S. Businesses and Real Estate Relative to Profitability of Similar Investments in Foreign Nations Foreigners also demand dollars to purchase U.S. corporate stock, real estate, and other assets. As the profitability of U.S. assets rises relative to that of assets in foreign nations, the demand for dollars to make such investments increases, putting upward pressure on exchange rates. Similarly, the supply of dollars to make direct investments in foreign nations decreases. This too puts upward pressure on the exchange rate of the dollar. Expectations of Future Changes in the Price of the Dollar in Terms of Foreign Currency The demand for and supply of a given currency also depend on the expectations of future changes in exchange rates. Expectations of a higher future price for the U.S. dollar will increase the current demand for dollars, putting upward pressure on the current exchange rate. Similarly, expectations of a decrease in the price of the dollar in terms of foreign currency will decrease the current demand for dollars and put downward pressure on the current exchange rate. If the exchange rate of the dollar is expected to rise, the supply of dollars will tend to decrease. U.S. importers will decide to wait until the exchange rate increases to make purchases from foreign nations, because an increase in the price of the dollar in terms of foreign currency causes a decrease in the price of foreign currency in terms of the dollar. Imports will become cheaper as the exchange rate of the dollar rises. The decrease in the current supply of dollars then puts upward pressure on the current exchange rate. The Price Level in the United States Relative to the Price Levels in Foreign Nations If the prices of U.S. goods go up by 10 percent relative to prices of competing goods supplied by foreign producers and the exchange rate is unchanged, it follows that the effective price of U.S. goods in foreign currency will also be 10-percent higher. This will decrease the quantity of U.S. goods demanded by foreign buyers, in turn decreasing the demand for dollars. The result will tend to reduce the exchange rate. Further, an increase in the U.S. price level relative to that in foreign nations will make foreign goods cheaper relative to U.S. goods, other things being equal. The increase in import demand will increase the supply of dollars offered on foreign exchange markets, putting still further downward pressure on the exchange rate of the dollar. Similarly, a fall in U.S. prices relative to foreign prices will increase the demand for U.S. exports and thus increase the price of the dollar in terms of foreign currency.