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The Interest Rate Transmission Mechanism

This series of step-by-step approaches looks at the concepts of the interest rate transmission mechanism. The activity will show you how changes in the interest rate impact on different sectors of the economy and what the consequences might be.

The Pound/Dollar Exchange Rate

This first animation looks at the effects of a change in the interest rate on the exchange rate. We assume that the analysis is from the perspective of the UK and thus look at the effect on the Sterling exchange rate.

We assume trade between the UK and the United States (US). A UK producer manufactures a product which is priced at £5. The UK producer sells to a buyer in the US but wants to be paid in £ Sterling. The US buyer must, therefore, buy Sterling and give up dollars to pay the UK seller. To the US buyer, the amount of dollars s/he has to give up to get the Sterling required is, in effect, the price they pay for the good from the UK.

Assume the initial exchange rate is £1 = $1.60 (the US buyer must give up $1.60 for every £1 required).

How much would the US buyer have to pay to buy the product from the UK seller?
Use your mouse cursor (or tab to the animation and use the a, b or c keys) to select the correct price. If correct the animation will start. You can stop/reset the animation by pressing q. The main introductory page features further accessibility information on these resources.


No Flash plugin detected: Animation would show the sale of a good to the United States from the UK. Animation would show the sale of a good to the United States from the UK and demonstrates the flow of money from the US to the UK. The US buyer will have to exchange dollars for pounds to pay for the good. The good is priced at £5 in the UK and at an exchange rate of £1 = $1.60, the price to the US buyer would be $8.

Notice that in this example, the UK seller receives money from the US buyer in return for selling the good. This represents an export to the UK and results in a flow of funds into the UK (export earnings) representing a positive entry on the balance of payments.

For the US, this transaction would represent an import and lead to a flow of funds out of the US (a negative entry on the balance of payments). The direction of the flow of money is the crucial point to remember when distinguishing between what represents the difference between 'imports' and 'exports'.

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