Foreign Rates Rise: The Dollar Depreciates
Higher interest rates abroad send American investors after foreign bonds, so they supply more dollars to buy foreign currency and the dollar depreciates.
Foreign Rates Rise: The Dollar Depreciates
Foreign Exchange Market (USD)Higher interest rates abroad send American investors after foreign bonds, so they supply more dollars to buy foreign currency and the dollar depreciates.
Equilibrium at Quantity of USD 80, Exchange Rate (foreign / USD) 1
Start at Equilibrium
The market for dollars starts in equilibrium where the demand for dollars (D$) crosses the supply of dollars (S$). The vertical axis measures foreign currency per dollar.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Students predict what happens before the graph moves. No accounts, nothing graded.
Foreign Rates Rise: The Dollar Depreciates, step by step
- 1
Start at Equilibrium
The market for dollars starts in equilibrium where the demand for dollars (D$) crosses the supply of dollars (S$). The vertical axis measures foreign currency per dollar.
- 2
Foreign Assets Start Paying More
Central banks abroad raise policy rates, so foreign bonds now offer a better return than comparable US bonds. An American investor who wants those bonds must first sell dollars for foreign currency, so more dollars are offered on the foreign exchange market at every exchange rate. The supply of dollars shifts right.
- 3
The Dollar Depreciates
At the new equilibrium the exchange rate is lower, so one dollar buys less foreign currency and the dollar has depreciated. The larger volume of dollars traded reflects the capital flowing out of US assets and into foreign ones.
- 4
Both Channels Weaken the Dollar
A second channel points the same way. Foreign investors now find US assets less attractive, so the demand for dollars falls too and pushes the exchange rate down further. Because both channels lower the exchange rate, the direction the dollar moves is never ambiguous. The quantity traded is different: the demand channel would pull it down while the supply channel pushes it up, so with both operating the quantity effect is indeterminate. Only the supply curve moves here, which isolates the American outflow and is why the quantity rises.
Where it ends up
American investors supply more dollars to chase higher foreign returns, so the supply of dollars shifts right and the dollar depreciates while the quantity of dollars traded rises.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
More Foreign Exchange Market (USD) walkthroughs
Last updated