Higher US rates lift the dollar

The chain in words

1. Step 1

   Before the rate rise

   This is the market for US dollars. The horizontal axis is the quantity of dollars traded. The vertical axis is the exchange rate in euros per dollar, so a higher rate means a stronger dollar. Europeans who want dollars are the demand, Americans who sell dollars for euros are the supply. The market is at E₀.

2. Step 2

   Demand for dollars shifts right

   Higher US rates make dollar bonds and deposits pay more. European investors want to buy them, and they need dollars to do it. At every exchange rate, more dollars are demanded, so demand for dollars shifts right. At the old rate there are more buyers of dollars than sellers.

3. Step 3

   The dollar appreciates

   Buyers bid the dollar up. As the dollar gets dearer, Americans find euros cheap and supply more dollars to buy them, a movement along supply. The market settles at E₁: the dollar has appreciated and more dollars change hands.

4. Step 4

   What a stronger dollar does

   A stronger dollar makes US exports dearer abroad and imports cheaper at home, so net exports fall. That is the exchange rate channel of monetary policy.

Takeaway. A rise in domestic interest rates raises demand for the currency and makes it appreciate.

Draw it yourself

More on the foreign exchange market graph