An interest rate is a rate which is charged or paid for the use of money. Rising interest rates drive up the US dollar. The rising US dollar has a significant impact on the US economy and thus stock market.
Rising US interest rates mean that a lot of people around the world will want to take advantage of higher interest rates inside the US. For simplicity sake, we will use just one country, Brazil, to illustrate what happens.
On the supply and demand graph S equals the supply of the Brazilian real and D equals demand for the real. If the exchange rate were one dollar for two reals, then the price of one real would be 50 cents.
When the Federal Reserve raises US interest rates, Brazilians will want to take advantage of higher interest rates on their savings, and so they will want to put more money in the US. To get the relatively higher interest rates in the US, Brazilians need to exchange Brazilian reals for US dollars. Thus, the supply of reals increases which shifts the supply curve outward.
The increased supply of reals is now used to buy US dollars, so the demand for dollars goes up which shifts the demand curve for dollars outward. This increase in demand for US dollars pushes the value of the dollar up. The supply and demand graph is S equals the supply of US dollars and D equals the demand for US dollars.
The dollar will now buy more reals, and it would take more reals to buy a dollar. The dollar has appreciated, and the real has depreciated.
The rising value of the dollar is good for US consumers as it makes imports cheaper and so demand for imports goes up. That’s bad for the domestic US economy because cheaper imports are purchased over more expensive domestically produced goods.
Another reason why a rising US dollar is not good for the US economy has to do with exports. A strong US dollar is bad for the US economy as it makes US exports more expensive and thus decreases US export sales.
A rising US dollar increases imports and decreases exports. If the value of the imports is greater than the exports, the country is said to have a trade deficit. The rising US dollar makes the trade deficit worse.
A trade deficit (Exports – Imports) subtracts from the GDP. In the GDP formula:
GDP = C + I + G + (Exports – Imports)
Having more imports than exports means US dollars are flowing out of the country and hence fewer dollars going into the “I” (business investment) component of the GDP formula.<< Back to Glossary Index