Interest Rate Determination

Suppose there is an increase in U.S. GDP, ceteris paribus. This will increase real money demand, causing a "downward" shift in the real money demand curve from L(i_$, Y_$′) to L(i_$, Y_$″) (step 1) in the Money-Forex diagram, Figure 18.10 "Effects of an Increase in GDP". (Remember, real money increases as you move down on the rotated money diagram). This causes an increase in the U.S. interest rate from i_$′ to i_$″ (step 2). The increase in the interest means that the rate of return on dollar assets increases from RoR_$′ to RoR_$″ (step 3). Finally, the increase in the U.S. RoR causes a decrease in the exchange rate from E′_$/£ to E″_$/£ (step 4). The exchange rate change corresponds to an appreciation of the U.S. dollar and a depreciation of the British pound. In summary, an increase in real U.S. GDP, ceteris paribus, causes an increase in U.S. interest rates and appreciation (depreciation) of the U.S. dollar (British pound).

Figure 18.10 Effects of an Increase in GDP