The Exchange Rate Channel
1. The Basic Chain: Interest Rates → Currency → Trade
Imagine two countries: the United States (using dollars, $) and Europe (using euros, €). If the U.S. central bank (the Fed) raises interest rates, holding dollars becomes more attractive. Why? Because investors get a higher return on savings and bonds in the U.S. To buy these American assets, international investors need dollars. They sell their euros to buy dollars, increasing the demand for the dollar.
This higher demand makes the dollar stronger or appreciate relative to the euro. Now, one dollar buys more euros than before. Here’s the impact on trade:
- For American exporters: Their goods priced in dollars now look more expensive for European buyers. A €50,000 European car now costs fewer dollars, but a $30,000 American machine costs more euros. U.S. exports likely fall.
- For American importers: Foreign goods (like European cars or Japanese electronics) become cheaper in dollar terms. U.S. imports likely rise.
Since Net Exports = Exports - Imports, a stronger currency usually causes net exports to decrease, slowing down economic growth. This is the exchange rate channel in action.
Higher Interest Rates → Stronger Currency → More Expensive Exports / Cheaper Imports → Lower Net Exports.
2. Real-World Example: The U.S. and Japan
Let’s look at a practical example between the U.S. and Japan. The Japanese currency is the yen (¥). Suppose the U.S. interest rate is 2% and the Japanese interest rate is 0%. The exchange rate is $1 = ¥100.
If the U.S. raises its interest rate to 4% while Japan’s stays at 0%, investors worldwide will want to move their money to the U.S. to earn that higher return. They sell yen and buy dollars. This increased demand for the dollar pushes its value up. The new exchange rate might become $1 = ¥110. The dollar is stronger (it now buys 10 more yen).
Now, think about a famous American product: Apple iPhones (assembled in China but counted as a U.S. export) and a famous Japanese product: Toyota cars.
| Item | Price in Local Currency | Price in Foreign Currency (Before Rate Hike) | Price in Foreign Currency (After Rate Hike & Appreciation) |
|---|---|---|---|
| iPhone (U.S. Export) | $800 | ¥80,000 (800*100) | ¥88,000 (800*110) More expensive for Japanese buyers |
| Toyota (Japanese Export) | ¥3,000,000 | $30,000 (3M/100) | $27,272 (3M/110) Cheaper for American buyers |
As the table shows, the iPhone becomes more expensive in Japan, so Japan will likely buy fewer of them (U.S. exports fall). The Toyota becomes cheaper in the U.S., so Americans will likely buy more of them (U.S. imports rise). The result is a drop in U.S. net exports.
3. Important Questions About the Exchange Rate Channel
A: Usually, yes. It attracts foreign investment, which increases demand for the currency. However, if investors think the high rate will cause a future economic crash, they might not invest. Also, if a country raises rates but another country raises them even more, the first country's currency might not strengthen as much.
A: Appreciation means a currency becomes more valuable compared to others. For example, if the dollar goes from buying €0.85 to buying €0.95, it has appreciated. Depreciation is the opposite—it becomes less valuable. If the dollar buys only €0.75, it has depreciated. A higher interest rate typically causes appreciation.
A: Net Exports are a part of a country's Gross Domestic Product (GDP)[1]. When net exports go down, it means the country is earning less from selling abroad relative to what it is buying. This directly subtracts from overall economic growth, potentially leading to less production and fewer jobs in export industries.
The exchange rate channel is a powerful way that monetary policy—like changing interest rates—affects the real economy. By influencing the value of the currency, central banks indirectly influence the price of goods traded internationally. A simple change in the interest rate can ripple through the economy, making a country's exports more or less competitive and shifting the balance of trade. Understanding this channel helps explain why investors and businesses watch central bank decisions so closely.
Footnote
[1] GDP (Gross Domestic Product): The total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period. It is a broad measure of overall domestic production and a key indicator of economic health.
[2] Net Exports: The value of a country's total exports minus the value of its total imports. It is also known as the trade balance.