Monetary policy influences exchange rates mainly through interest rates and international financial flows. Understanding this transmission helps explain why a central bank’s actions can strengthen or weaken a currency and shift key macroeconomic outcomes.

Core link: monetary policy to interest rates to exchange rates

Monetary policy and interest rates

When a central bank changes monetary policy, it alters short-run interest rates, which changes the attractiveness of domestic financial assets to global investors.

Expansionary policy (e.g., open-market purchases) tends to lower short-run interest rates; contractionary policy (e.g., open-market sales) tends to raise short-run interest rates.

Money market equilibrium diagram with a vertical real money supply curve ($M/P$) and a downward-sloping real money demand curve ($L(i,Y)$). The intersection determines the equilibrium nominal interest rate, illustrating how an expansionary monetary policy (rightward shift of $M/P$) lowers interest rates, while a contractionary policy raises them. Source

These interest-rate changes are a key channel through which exchange rates respond.

Interest rates and demand for a currency

Higher domestic interest rates (relative to foreign rates) generally increase demand for the domestic currency because investors must buy the domestic currency to purchase domestic assets (bonds, deposits). Lower domestic interest rates generally reduce demand for the domestic currency.

This relationship is typically analysed through international capital flows:

• If domestic interest rates rise relative to foreign rates:

  • foreign investors buy more domestic assets

  • demand for domestic currency increases

  • the domestic currency tends to appreciate

• If domestic interest rates fall relative to foreign rates:

  • investors shift toward higher-yielding foreign assets

  • demand for domestic currency decreases

  • the domestic currency tends to depreciate

How exchange rates are measured and interpreted

An exchange rate is the price of one currency in terms of another; wording and quoting conventions matter.

With this common quote, an increase in $E$ means it takes more domestic currency to buy 1 unit of foreign currency, so the domestic currency has depreciated. A decrease in $E$ implies appreciation.

The macroeconomic transmission emphasised by the syllabus

The syllabus highlights that monetary policy can change aggregate demand, real output, the price level, and interest rates, thereby affecting exchange rates. The key channels are:

1) Interest-rate (asset demand) channel → exchange rate

• Central bank tightens policy → interest rates rise

• Domestic assets become relatively more attractive

• Currency appreciates (via higher demand for domestic currency)

The opposite tends to occur under easier monetary policy: interest rates fall and the currency tends to depreciate.

2) Aggregate demand channel (including exchange-rate effects)

Monetary policy changes aggregate demand (AD) primarily through interest-sensitive spending and financial conditions. The exchange rate can reinforce AD changes by affecting the relative prices of domestic versus foreign goods, changing spending patterns across borders.

3) Real output and price level implications

Because AD shifts affect short-run equilibrium:

AD–AS diagram illustrating an aggregate demand increase (AD shifts right) and the resulting rise in both real output and the price level in the short run. The figure also shows how subsequent adjustment of short-run aggregate supply can move the economy back toward potential output in the long run, linking monetary-policy-driven AD changes to output and inflation outcomes. Source

• Easier monetary policy can raise real output and the price level in the short run; the associated lower interest rates often coincide with currency depreciation

• Tighter monetary policy can reduce inflationary pressure, lowering the price level relative to what it would have been; the associated higher interest rates often coincide with currency appreciation

Important qualifiers for AP-style reasoning

Exchange-rate responses depend on expectations and relative conditions, so answers should be framed as tendencies:

• Relative interest rates matter (domestic versus foreign), not the domestic rate alone.

• If foreign central banks change policy simultaneously, the net exchange-rate effect may be smaller or ambiguous.

• Investor expectations about future policy, inflation, and risk can shift currency demand even before interest rates fully adjust.