Question

The following is a quote from The Economist (Dec. 3, 2016):

“The dollar has been gradually gaining strength for years. But the prompt for this latest surge is the prospect of a shift in the economic-policy mix in America. The weight of investors’ money has bet that Mr. Trump will cut taxes and spend more public funds on fixing America’s crumbling infrastructure. A big fiscal boost would lead the Federal Reserve to raise interest rates at a faster rate to check inflation. America’s ten-year bond yield has risen to 2.3%, from almost 1.7% on election night. Higher yields are a magnet for capital flows.”

There has also been Fed attempts to raise interest rates recently.

EXPLAIN IN A PARAGRAPH: Will higher US interest rates strengthen the USD? Agree or disagree. Explain fully. Also, will the resulting change in the USD (from your analysis) be consistent with President Trump’s overall economic perspective on trade and US manufacturing.

Please address these questions from a Jan. 1, 2017 perspective for that time period.

Answer 1

I agree that the higher US interest rates strengthen the USD. When the Fed raises interest rates ,investors looking for return tend t sell assets denominated in foreign currencies and buy dollar denominated assets. The wider the spread between US interest rates and interest rates in other countries ,the more investors are likely to move from foreign - denominated to dollar - denominated assets. In order to purchase dollar denominated asset ,investors need dollars . So they exchange other currencies for dollar and their increased demand for dollar raises the dollar exchange rate.

When the Fed raises rates ,strengthening the dollar ,the currency exchange rates of other countries tend to weaken.

The higher yields attract investment capital from investors abroad seeking higher return on bond and interest rate product.

A Stronger dollar aids in making foreign imports cheaper and act as a natural hedge for reducing inflation risk in the economy. The Fed monitors inflation closely along with the level of strength of the dollar before making any decision regarding the fed fund rate.