Relation between Exchange Rates, Interest Rates and Flow of Funds

Exchange Markets, Interest Rate Markets and Funds Flow

Its time now to bring it all together to fully understand the relation between the three.

We have studied the effects of inflows and outflows of funds in the interest rate market. We have studied the effects of foreign funds flow in the exchange rate market. These two markets are linked by one common entity – net investments by foreigners. The net lending of $60 billion is the same in both markets. When these flows come in or flow out of the country it affects both markets. The reverse is also true. Any change in the exchange rate market affects the foreign asset HPY and in turn net investments by foreigners. This change in net investments by foreigners impacts the interest rate markets in a manner that we have already seen.

Similarly a change in interest rates affects net investments by foreigners as the interest yield component of the HPY is affected. This effect on net investments by foreigners then has an impact on the exchange rate markets and financial markets in general.

Now finally we wrap up this section by taking case scenarios that link economic indicators, economic entities, interest rates, exchange rates and fund flows.

Factors Affecting the Exchange Rate and Interest Rate Markets

Lets take some real world scenarios that link economic indicators, economic entities, interest rates, exchange rates and fund flows so we can start making the connections.

We have already seen how government deficits increase borrowing by the government sector causing a shift in the demand curve. This shift of the demand curve to the right causes interest rates to move higher. An increase in interest rates makes investing or lending more attractive to foreigners as their expected comparative yield increases. This increase in foreign investments impacts the exchange rate markets when foreign investors exchange their holding currencies for dollars. The demand for dollars strengthens the USD against foreign currencies thereby increasing the exchange rate. An exchange rate increase also has an impact on exports and imports as we have seen, causing a fall in exports and a rise in imports increasing the trade deficits.

Lets see the effects of a rise in foreign interest rates on US interest rates and the exchange rate markets

When foreign interest rates rise the comparative yield of the foreign asset becomes more attractive than the US asset. This causes a flow of funds from US assets to the foreign asset. This reduction of net investment in the US causes a reduction in the supply of funds therefore an increase in interest rates. Funds will flow out of the US into the foreign asset causing the demand for USD to fall and in turn the dollar to fall against the foreign currency. At a lower exchange rate US exports become more attractive and rise whereas imports fall. This increase in exports and decrease in imports narrows the trade deficit.

Similarly once we understand the relationships between funds flow, economic entities that contribute to the flow of funds, economic indictors that bring about shifts to the demand and supply of funds, linkages between the flow of funds, interest rates and exchange rates – we can start making connections much more easily to the economic situation surrounding us.

However there is still one missing link. We first discussed the banking system’s effect on the money supply and then moved on to forming relationships between the flow of funds by various entities, interest rates and exchange rates. While these two topics appear to be very distinct they are linked and we shall see how.



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