Interest Rate Differential
The question
Assume the foreign exchange market for the US dollar is initially in equilibrium. Interest rates on US bonds rise relative to interest rates on comparable British bonds, and financial investors in the United Kingdom respond by purchasing more US bonds. Show the effect of these bond purchases in the foreign exchange market for the US dollar, holding all else constant. Show the effect on the Foreign Exchange Market (USD) graph.
Drag a curve, or use the arrow buttons. Want the free-play version with every control? Open this graph in the sandbox.
Interest Rate Differential: the worked answer
On the Foreign Exchange Market (USD) graph, Demand for dollars (D$) shifts right.
Why Demand for dollars (D$) shifts right
Higher relative US interest rates make US bonds more attractive to British investors. To buy US bonds, those investors must first exchange pounds for dollars, which raises the quantity of dollars demanded at every exchange rate. Because the buyers are foreigners acquiring dollars, this is a change in the demand for dollars, and it shifts right. The supply of dollars, which comes from Americans buying foreign goods and assets, is unaffected here.
What happens to the equilibrium
The dollar appreciates and the equilibrium quantity of dollars traded increases.
The mistake students make on this one
A frequent wrong answer is shifting the supply of dollars left, on the idea that capital flowing into the United States pulls dollars out of circulation. British investors are not selling dollars, they are buying them, so the only side of this market that changes is the foreign side that must acquire dollars first.
On exam day
When an interest rate moves in the country whose currency the graph measures, ask whose assets just became more attractive. Foreigners buying US assets is always a D$ shift, never an S$ shift.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when Demand for dollars (D$) shifts right and every other curve on the Foreign Exchange Market (USD) graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
More Foreign Exchange Market (USD) scenarios
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