7.3.1. International Economic Activity and Foreign Exchange Rates
Domestic economic activity in any major country has global implications. High interest rates in one country bring inflows of investment capital from other countries. But investing in another country can affect a country’s domestic economy—an outflow of capital means less money to invest domestically, a reduced productive capacity, and higher unemployment. Countries that artificially keep their exchange rates low to encourage their export industries artificially inflate another country’s imports and discourage the other country’s exports.
Countries that fear a high influx of capital may hoard increasing amounts of another country’s money as protection, thereby increasing the demand for that other country’s currency and increasing its price. Monetary policy in the U.S. must balance these competing interests using its tools of adjusting the federal funds rate and foreign currency purchases.
When a currency other than the local currency is used to settle international transactions, it is referred to as foreign exchange. The rate at which two currencies trade for each other is known as the exchange rate. Suppose $1 today exchanges for the euro at €0.75. If the dollar rises or strengthens relative to the euro, $1 will be able to buy more euros, say €1.00. If it can buy more euros, it can buy more European goods. Europeans, in turn, will see their euro weaken in terms of the dollar.
As the dollar strengthens, Americans will buy more imports, and American exports will decrease. Conversely, a falling dollar