Policy Changes and the Currency Market

Foreign investors chase the best return on their money. If a country's real interest rate rises, bonds and bank deposits there pay more, so investors abroad want to hold those assets. To buy them, they first need the local currency, so they sell their own currency and buy this one. That shifts demand for the currency right on the loanable-funds-meets-currency-market story, and the currency appreciates. Drop the real interest rate, and the logic reverses: assets there look less attractive, demand for the currency falls, and it depreciates.

This is why expansionary monetary policy is a trap for the intuition that 'expansion always helps.' Cutting the policy rate boosts output and spending at home, but that same rate cut makes the currency less attractive to foreign capital, so it depreciates. Expansionary fiscal policy works oppositely on the currency: more government borrowing pushes up the real interest rate in the loanable funds market, which then pulls in foreign capital and appreciates the currency, even though both policies count as 'expansionary.'

Trace the full chain to connect this to net exports: a policy changes the real interest rate, the interest rate changes foreign demand for the currency, the currency's value changes, and that changes net exports. A stronger currency makes exports pricier abroad and imports cheaper at home, so net exports fall. A weaker currency does the opposite. The exchange rate is the hinge between the money or loanable funds market and the trade balance.