Money, interest rates, and the exchange rate
So far, we have examined the institutional details of the foreign exchange market and explained what determines the exchange rate. The model of exchange rate determination that we developed in the previous chapter explains some of the movement in exchange rates. Both the rate of inﬂation and the growth rate of GDP of a country usually do not change dramatically over short periods of time, such as one day to the next. Yet, exchange rates change almost every minute of every business day. As a result, we need to expand our model of exchange rate determination to include another factor that determines or inﬂuences exchange rate movements over short periods of time. This factor is short-term interest rates. Since interest rates have an important inﬂuence on the exchange rate, we need to describe what causes domestic interest rates to change. In the ﬁrst part of the chapter, we will review and expand on what you learned in your Principles of Economics course concerning the supply and demand for money and the determination of the equilibrium interest rate within a domestic economy.