The sluggish economy in the U.K. causes England’s central bank to reduce its interest rates.

Question

Draw correctly labeled side-by-side graphs for the British pound and the U.S. dollar showing how the change in the U.K.’s interest rates will affect the 2 countries’ currencies. What is the effect on the international value of the U.S. dollar and the Pound?

Answer 1

U.K FOREX Graph:

1. Demand for Pounds decreases (shifts left) - Americans want less U.K. securities
2. Supply of pounds Increases (shifts right) - More pounds are supplied to the FOREX to purchase U.S. securities due to relatively higher interest rates in the U.S.

U.S. FOREX Graph:

1. Demand for dollars increases (Shifts right) - More people want U.S. securities due to relatively higher interest rates in the U.S.
2. Supply of dollars decreases (Shifts left) - Less Americans supply dollars to the FOREX in order to buy U.K. securities due to relatively lower interest rates.

The dollar appreciates and Pounds depreciate relative to the dollar.

1. Interest rates are a double shifter; Both supply and demand for each currency change.

Lower interest rates = Lower return for investors. Investors will look to invest In countries that offer higher interest rates.

1. Demand in U.K. FOREX = Demand for Pounds by Americans
2. Demand in U.S. FOREX = Demand for dollars by England
3. Supply in U.K. FOREX = Supply of pounds by England (Supplied to buy U.S. goods/services)
4. Supply in U.S. FOREX = Supply of dollars by America (Supplied to buy U.K. goods/services)

So, when interest rates decrease in England, less dollars will be supplied to the FOREX to buy U.K. securities and more Pounds will be supplied to U.S. FOREX to buy U.S. securities. Demand for Pounds decreases in the U.K. Forex and Demand for dollars increases in U.S. Forex.