Question: If interest rates fall in the US how does this affect US exchange rate.

A) we discussed the fact that lower interest rates will reduce the demand for

US interest bearing assets (checking accounts and bonds). This therefore

Shifts the demand for currency backward and puts downward pressure on the

Interest rate.

B) the question was raised, if foreigners wish to borrow US funds at these low

Interest rates, will this not raise demand for dollars and raise the exchange rate.

NO. In this case the foreigners are exporting assets (IOU, interest bearing notes).

The consequence of this is that the US is importing assets (Portfolio Investments

in the Capital Account). We see this as a shift in the supply Curve of US dollars,

which are tendered in order for US citizens to buy the Foreign IOUs (assets). The

increase in supply of dollars further depresses the Dollar exchange rate.

STILL, some of you have asked, don't British citizens want to borrow from the

US as the low rates. YES, they do. But doen't this raise the demand for dollars?

NO. The British are suppling the IOUs (bonds--as this is what it means to borrow)

while the US citizens are supply the $, which must be exchanged for pounds. The

increase supply of dollars is the same as an increase in the demand for pounds..

AS A FINAL and MORE ADVANCED ASIDE. Doesn't this constitute arbitrage, and

if so, why don't interest rates converge? In fact they. Two things are happening

here. As Americans buy foreign assets their price rises. So if you were buying bonds,

it is possible that a $100 bond would rise in price to 105. If the British were paying

10% interest, then this effectively lowering the interest rate.

Why? Because instead of buying bonds at 100 and receiving $10 back (or 10%)

Americans are now payiong 105 and receiving the same $10. The rate of return has dropped

because American's are paying more for the bonds, but getting the same return.

The process can also happen in reverse in the US, where effective interests

will increase as US lender go abroad, rather than serve their own debtors.