9.4: Interest rates and foreign exchange rates (2024)

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The interest rates determined in the money market have important effects on the foreign exchange rate. With free international trade in financial assets, portfolio managers, having chosen to hold some part of their portfolios in bonds, have an additional choice. They can hold some bonds issued by domestic borrowers and some issued by foreign borrowers. They might, for example, hold some bonds issued by the Government of Canada, some issued by the United States Treasury and some issued by other governments. Similarly, residents of other countries can choose to include bonds issued by the Government of Canada in their holdings. These choices are made on the basis of the yields on bonds established by conditions in different national money and bond markets.

Foreign exchange rate: the domestic currency price of a unit of foreign currency.

To achieve the highest return on the bond portion of their portfolios, managers buy bonds that offer the highest rate of return for a given level of risk. If interest rates are constant in other financial markets, a rise in Canadian interest rates and bond yields makes Canadian bonds more attractive to both domestic and foreign bondholders. The demand for Canadian bonds increases. A fall in Canadian interest rates has the opposite effect.

Bonds are issued and priced in national currency. Most Government of Canada bonds are denominated in Canadian dollars. US Treasury bonds are denominated in US dollars, and bonds issued by European governments are denominated in euros. If Canadians want to purchase bonds on foreign bond markets they need foreign currency to make payment. Similarly, if residents of other countries want to purchase Canadian bonds they need Canadian dollars to make payment. These foreign exchange requirements for trading in financial assets are the same as those for trading in goods and services. The foreign exchange market is the market in which currencies of different countries are bought and sold and foreign exchange rates are determined.

Foreign exchange markets and rates are examined in detail in Chapter 12. For now it will be enough to consider the effects of changes in domestic interest rates on the foreign exchange rate.

Consider an increase in the domestic money supply in Canada. Money and bond market adjustments to this increased money supply lower the Canadian interest rate. At these lower interest rates domestic bond yields are lower relative to foreign bond yields than they were before. This provides the incentive for domestic portfolio managers to switch their purchases from domestic bonds to foreign (US) bonds. To pay for foreign bonds they need foreign currency. The demand for US dollars increases.

Simultaneously, bond holders in the US shift their purchases from the now relatively low-yield Canadian bonds to US bonds. Lower sales of Canadian securities in the US market reduce the supply of US dollars. This drop in the supply of US dollars combined with the increase in demand raises the Canadian dollar price of U.S dollars. This is a depreciation of the Canadian currency. If the initial exchange rate was $1.20Cdn = 1.00US, the exchange rate would be somewhat higher, say $1.25Cdn = $1.00US

Depreciation of the national currency: a decline in the value of the currency relative to other national currencies, which results in a rise in the domestic price of foreign currencies.

In this example a fall in domestic interest rates, other things constant, causes depreciation in the domestic currency relative to foreign currencies. This interest rate-exchange rate linkage is symmetrical. Rises in domestic interest rates cause appreciation of the national currency.

Appreciation of the national currency: an increase in the value of the currency relative to other national currencies, which results in a fall in the domestic currency price of foreign currencies.

A decrease in the money supply or a change in the demand for money with a fixed money supply would affect the foreign exchange rate through the same linkages. Changes in domestic financial markets and foreign exchange markets happen simultaneously. With current communications and information technology these markets adjust very rapidly and continuously. The changes in interest rates and foreign exchange rates that result from changes in domestic money market conditions have important effects on aggregate expenditure and aggregate demand.