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Using the foreign exchange model, illustrate how higher interest rates in the US can cause the...

Using the foreign exchange model, illustrate how higher interest rates in the US can cause the US dollar to appreciate? Explain your graph

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Answer #1

Consider the following fig of “foreign exchange market”.

So, here “D1” and “S1” are the demand and the supply of foreign exchange market, => “e1” be the equilibrium, => the equilibrium exchange rate is “E1”. Now, as the interest rate increases, => foreign investor starts investing in to US, => there will massive capital inflow, => the supply of foreign exchange increases to “S2”, => the new equilibrium is given by “e2”, => the new exchange rate is given by “E2”, => as the exchange rate decreases implied appreciation of dollar.

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