The Connection Between Interest Rates and Exchange Rates r NCO E dollars NCO D = NX S 1 = NCO 1 S2S2 E1E1 E2E2 r1r1 r2r2 Anything that increases r will reduce NCO and the supply of dollars in the foreign exchange market. Result: The real exchange rate appreciates. NCO 1 NCO 2 NCO 1 NCO 2 Keep in mind: The LF market (not shown) determines r. This value of r then determines NCO (shown in upper graph). This value of NCO then determines supply of dollars in foreign exchange market (in lower graph).
Figure The effects of a government budget deficit The whole thing put together 21 Real Interest Rate S1S1 Demand Quantity of Loanable Funds (a) The Market for Loanable Funds Real Interest Rate NCO Net capital outflow (b) Net Capital Outflow r1r1 Real Exchange Rate S1S1 Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange E1E1 When the government runs a budget deficit, it reduces the supply of loanable funds from S 1 to S 2 in panel (a). The interest rate rises from r 1 to r 2 to balance the supply and demand for loanable funds. In panel (b), the higher interest rate reduces net capital outflow. Reduced net capital outflow, in turn, reduces the supply of dollars in the market for foreign-currency exchange from S 1 to S 2 in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate from E 1 to E 2. The appreciation of the exchange rate pushes the trade balance toward deficit. S2S2 r1r1 A 1. A budget deficit reduces the supply of loanable funds... r2r2 B 2.... which increases the real interest rate... r2r2 3.... which in turn reduces net capital outflow. S2S2 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency... E2E2 5.... Which causes the real exchange rate to appreciate.