506 PA R T V I International Finance and Monetary Policy Conversely, if i D falls, the relative expected return on dollar assets falls, the demand curve shifts to the left, and the exchange rate falls A decrease in the domestic interest rate iD shifts the demand curve for domestic assets, D, to the left and causes the domestic currency to depreciate (E T ) Suppose that the foreign asset pays an interest rate of i F When the foreign interest rate i F rises, holding the current exchange rate and everything else constant, the return on foreign assets rises relative to dollar assets Thus the relative expected return on dollar assets falls Now people want to hold fewer dollar assets, and the quantity demanded decreases at every value of the exchange rate This scenario is shown by the leftward shift of the demand curve in Figure 19-5 from D1 to D2 The new equilibrium is reached at point 2, when the value of the dollar has fallen Conversely, a decrease in i F raises the relative expected return on dollar assets, shifts the demand curve to the right, and raises the exchange rate To summarize, an increase in the foreign interest rate iF shifts the demand curve D to the left and causes the domestic currency to depreciate; a fall in the foreign interest rate iF shifts the demand curve D to the right and causes the domestic currency to appreciate FOREIGN INTEREST RATE, I F e Expectations about the future value of the exchange rate play an important role in shifting the current demand curve, because the demand for domestic assets, like the demand for any durable good, depends on the future resale price Any factor that causes the expected future exchange rate, Ete+ , to rise increases the expected appreciation of the dollar The result is a higher relative expected return on dollar assets, which increases the demand for dollar assets at every exchange rate, thereby shifting the demand curve to the right in Figure 19-6 from D1 to D2 The equilibrium exchange rate rises to point at the intersection of the D2 and S curves CHANGES IN THE EXPECTED FUTURE EXCHANGE RATE, E t + Exchange Rate, Et (euros/$) E1 E2 S D2 D1 Quantity of Dollar Assets F I G U R E 19 - Response to an Increase in the Foreign Interest Rate, i F When the foreign interest rate i F increases, the relative expected return on domestic (dollar) assets falls and the demand curve shifts to the left The equilibrium exchange rate falls from E1 to E2