Here is an excerpt from one of the news readings \"Dollar\'s decline speeds up..

Question

Here is an excerpt from one of the news readings "Dollar's decline speeds up.." posted online. "The dollar fell nearly 1% against a broad basket of currencies this week, following a drop of similar size last week. The ICE U.S. Dollar Index closed at its lowest level since August 2008, before the financial crisis intensified. "The dollar just hasn't had anything positive going for it," said Alessio de Longis, who oversees the Oppenheimer Currency Opportunities Fund. The main driver for the dollar's decline is low interest rates in the U.S. compared with higher and rising rates abroad. Lower rates mean a lower return on cash-and the pressure from that factor could intensify next week when the Federal Reserve's rate-setting committee is expected to signal that U.S. short-term rates will likely remain near zero for many months to come." Using the money market and interest parity equilibrium explain how a relative increase of foreign interest rate leads to dollar's depreciation.

Explanation / Answer

In an open economy, there are mobility of capital from one country to another. This mobility depends on the rate of return on capital which further depends on the interest rates prevailing in an economy. Keeping the risk factor as neutral, the nation which pays more interest rates, the capital would be inflowed in that nation and outflowed from others.

From the article it is clear that in U.S the interest rates are quite low because of which the capital outflowed from U.S and inflowed into that nation where there were relatively high interest rates.

When the capital moved out from U.S, the demand for U.S dollars declined. Also, the demand for foreign currency increases, because of which the supply of dollars increases and exceeds the demand. Having flexible exchange rate, the immediate effect is a depreciation of U.S dollars.

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