Question

Assume that all countries are under the floating exchange rate system, and the Federal Reserve (Fed) is raising the interest rate to lower the inflation rate in the U.S. How will the higher interest rate impact the capital inflow and capital outflow of the U.S., and thus the demand and supply of U.S. dollar in the foreign exchange market?

Answer 1

Higher interest rates in the U.S. attract foreign capital, increasing demand for U.S. dollars and leading to an appreciation of the exchange rate, which can result in a larger trade deficit.

Step-by-step explanation:

When the Federal Reserve raises interest rates to tackle inflation in the U.S., this creates several impacts on capital flows and the foreign exchange market. A higher domestic interest rate typically attracts capital inflow from foreign investors seeking a better rate of return, leading to an appreciation of the U.S. dollar. This appreciation is due to an increased demand for U.S. dollars and a decreased supply in the foreign exchange market as Americans find U.S. bonds more attractive and buy fewer foreign bonds. Conversely, capital outflow decreases when domestic investors prefer to invest within the country due to the higher returns. This appreciation of the U.S. dollar can lead to a larger trade deficit as the strengthened currency makes U.S. exports more expensive and imports cheaper.