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Why Does the Dollar Decline When Interest Rates Go Up?

by Catherine Capozzi ; Updated September 26, 2017
The dollar's value reacts to changes in the money supply.

The dollar and interest rates are inextricably linked with one factor bonding the two together: the money supply. Changing the interest rate changes the money supply. Consequently, when the money supply increases or decreases, the value of the dollar changes as well. The primary party responsible for these changes is the Federal Reserve. Despite the fact that adjustments are made with the best of intentions, modifying interest rates causes positive and negative effects felt at home and abroad.

Interest Rates and the Money Supply

The Federal Reserve assesses the economy and adjusts the interest rate based on its desired expectations. The Fed raises nominal interest rates to discourage banks from loaning money. Because borrowing money costs more when interest rates are higher, consumers tend to borrow less and save more. When interest rates are high, consumers are much less likely to buy homes and other expensive items that require taking out a bank loan. In turn, when banks do not loan as much money, less money is created and flushed into the economy: Overall, the money supply decreases when interest rates go up.

Dollar Value and the Money Supply

The money supply contracts when the Fed raises interest rates. A contraction in the money supply means fewer dollars are chasing goods and services. Because less money is in circulation, the dollar’s purchasing power grows stronger. The scarcity of dollars is one reason for the increase in purchasing power, and another is due to sellers dropping the price of goods to entice consumers to spend money. Thus, the quantity of dollars decreases when interest rates rise, but the amount of goods and services a dollar can purchase increases.

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Benefits

A stronger dollar and high interest rates can be beneficial to the U.S. economy, specifically with trade. Exporting goods to businesses overseas is more expensive, but importing goods becomes cheaper. Businesses reliant on imports experience a reduction in the cost of production thanks to a strengthened dollar. Furthermore, while low interest rates, inflation and rising prices erode the value of a person’s savings, deflation and a strong dollar have the opposite effect. Therefore, citizens who choose to invest money in savings experience a rise in personal wealth when interest rates go up.

Negative Consequences

A decline in the number of dollars available in the economy has negative consequences as well. Greg Mankiw, author of “Brief Principles in Macroeconomics,” explains that in the short run, rising interest rates increase the unemployment rate. Because fewer dollars are circulating in the economy, firms have to lay off workers due to the decline in consumer consumption. A strong dollar also correlates with higher trade deficits. Jeff Madura, author of “International Financial Management,” states that a strong dollar creates incentives to purchase more goods from abroad and disincentives to export products.

References

  • “Brief Principles in Macroeconomics”; Gregory Mankiw; 2008
  • “International Financial Management”; Jeff Madura; 2008

About the Author

Since 2008 Catherine Capozzi has been writing business, finance and economics-related articles from her home in the sunny state of Arizona. She is pursuing a Bachelor of Science in economics from the W.P. Carey School of Business at Arizona State University, which has given her a love of spreadsheets and corporate life.

Photo Credits

  • Pennies on the Dollar - one dollar bill with pennies. image by Andy Dean from Fotolia.com
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