How do the Fed's actions change the exchange rate?

Question

What will be an ideal response?

Answer 1

A change in the U.S. interest rate changes the U.S. interest rate differential. For example, a rise in the U.S. interest rate, other things remaining the same, means that the U.S. interest rate differential increases. When the U.S. interest rate differential increases people want to move funds from other countries into the United States to obtain the relatively higher returns on U.S. assets. To move funds into the United States, people buy dollars and sell other currencies, driving the price of the dollar up. A higher dollar means that foreigners must pay more for U.S.-made goods and services and Americans pay less for foreign goods and services. So the rise in the interest rate means that exports decrease and imports increase, corresponding to a fall in net exports.