[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

While this discussion has focused on the demand for dollars by foreign investors,
the supply of dollars in the foreign exchange market will also be affected. With U.S.
interest rates higher, U.S. investors will be less likely to buy foreign securities, thereby
reducing the supply of dollars in the foreign exchange market. Again, the result is to
raise the value of the dollar as demand increases and supply decreases.
Our discussion took as its starting point a rise in U.S. interest rates. Though the
increase leads to an appreciation of the dollar, from the perspective of other countries
it causes their currencies to depreciate. For example, if U.S. interest rates rise relative
to interest rates in Canada, the Canadian dollar will depreciate, falling in value
relative to the U.S. dollar. To take another example: in June 2000, the European Central
Bank boosted interest rates. Because higher returns could now be earned on European
financial assets, investors sold off some holdings of dollar assets in order to invest in
euro assets. But to make those investments, they needed to use their dollars to buy
euros. The greater demand for euros pushed up the price of euros in terms of
dollars—that is, the exchange rate changed and euros appreciated relative to dollars.
Two points are worth noting. First, the value of the dollar is affected by changes
in interest rates in other countries. This point illustrates just one of the ways in
which international economic developments can affect the U.S. economy. Second,
in our examples of how interest rates affect exchange rates, interest rates in one
country change relative to interest rates in other countries—and that change is what
causes investors to shift funds in pursuit of higher returns. If the Fed raises the
interest rate in the United States and other countries respond by increasing their
interest rates, the dollar will not appreciate.
THE EXCHANGE RATE AND AGGREGATE
EXPENDITURES
Changes in the value of the dollar affect net exports. As the dollar appreciates, U.S.
exports fall and imports rise. As dollars become more expensive, foreign buyers find
that U.S. goods cost more in terms of their own currencies. Faced with this increase
in cost, they will buy fewer goods produced in the United States. And conversely, foreign
goods are now cheaper for Americans to purchase since dollars buy more in terms
of other currencies. U.S. imports rise as Americans buy more goods produced abroad.
The fall in exports and rise in imports mean that U.S. net exports fall. Thus the
total demand for U.S. goods and services (consumption plus private investment plus
government purchases plus net exports) falls. As firms producing for the export
market see their sales decline, and as consumers shift their spending toward imported
goods, total production and employment in the U.S. decline.
As a result, the ADI curve continues to have a negative slope when we take into
account that modern economies are open economies. Just as in our earlier analysis,
a rise in inflation leads the central bank to boost the real interest rate, and this
increase reduces private spending, particularly investment spending. In addition,
as the interest rate rises, the dollar appreciates; net exports are therefore reduced.
So equilibrium output falls when inflation rises, because investment spending and
net exports fall. A movement along a given ADI curve now involves changes in both
the interest rate and the exchange rate.
THE ADI CURVE AND THE OPEN ECONOMY ∂ 781