If you ever wonder how the interest rates, capital flow and foreign exchange rates are linked, review this slide for a quick glimpse of how these variables work.

1. Relationship – Monetary Policy, Interest Rate, Economic
Activity and Foreign Exchange
Key Assumptions:
• Focus on aggregate demand in an economy
• Sufficient slack in the economy to allow increases in
the output without increase in price levels (i.e. there is
a gap between potential and actual GDP and increase
in demand will not affect prices and inflation)
• Free flow of capital between countries (economies) is
allowed
• Flexible foreign exchange rates
Monetary Policy(MP)
–
Expansionary/
Restrictive
Expansionary: When economy’s central bank
reduces interest rates
Restrictive: When economy’s central bank
increases interest rates
Expansionary MP
INTEREST
RATE
ECONOMICA
CTIVITY
FOREIGN
CAPITAL
OUTFLOW
DOMESTIC
CURRENCY
RESTRICTIVE MP
INTEREST
RATE
ECONOMICA
CTIVITY
FOREIGN
CAPITAL
INFLOW
DOMESTIC
CURRENCY
When monetary policy is expansionary (i.e. the interest rates
are reducing), the flow of domestic money in an economy
rises but the market becomes less attractive for foreign
investors, which induces investment sell-off and withdrawal of
foreign currency from domestic economy. This leads to
downward pressure on domestic currency (i.e. depreciation of
domestic currency)
When monetary policy is restrictive (i.e. the interest rates are
rising), the flow of domestic money in an economy reduces
but the market becomes more attractive for foreign
investors, which induces fresh foreign investments in the
domestic economy. This leads to upward push on the
domestic currency (i.e. appreciation of domestic currency)
Note:
Fiscal policy also
plays a critical role
in the movement of
exchange rates
Property of: FAMiniConcepts