By using the covered arbitrage model to explain the flows the occur when the US changes its target for the Federal Funds rate, understanding will happen with regards to worldwide currency markets.  First, assume the Federal Funds rate is lowered and the other countries do not follow the United States’ move.  Next, The other countries follow the reduction of the Federal Funds rate by lowering their short-term interest rates.  By discussion the covered arbitrage model, the global currency market is better understood.

            First, assume the Federal Funds rate is lowered and the other countries do not follow the United States’ move.  Since the other countries do not follow the United States’ move, there will be a disturbance in the equilibrium between the domestic (United States) short-term rate and the foreign exchange adjusted foreign rate.  Since the domestic rate is now lower, the market will be move toward equilibrium because the spot rate will depreciate to a point where the market is balanced.  The flow of currency would be away from the dollar to the other currency because the other currency offers a better interest rate.  Because the dollar has depreciated, the American goods become cheaper in the other country.  This results in higher exports from the United States to the foreign country. The opposite is true in the foreign country.  Because their currency has increased, exports to the United States will decrease because the price of goods has relatively increased in the United States.  This could be beneficial if the other countries wanted cheaper goods from the United States, but if the country is a big exporter to the United States this spot rate increase would be detrimental.  This example is if the country did not follow the United States move to lower the Federal Funds Rate.

            Next, The other countries follow the reduction of the Federal Funds rate by lowering their short-term interest rates.  Initially, the adjusted foreign rate will be higher than the domestic rate.  This is heavily based on the fact that the other countries “follow” the United States.  This means that the change is not instantaneous.  This result will not last because the other countries follow and the equilibrium of the currency market is restored to its previous balance.  In respect to the flows, initially the flows would increase to the other markets, but once the balance is restored the flows will return to their previous course. Because the flows are the same, the import and export levels will remain at there current levels.   In this case, the other countries follow the movement of the Federal Funds rate.

            By using the covered arbitrage model to explain the flows the occur when the US changes its target for the Federal Funds rate, understanding will happen with regards to worldwide currency markets.  First, assume the Federal Funds rate is lowered and the other countries do not follow the United States’ move.  Next, The other countries follow the reduction of the Federal Funds rate by lowering their short-term interest rates.  By discussion the covered arbitrage model, the global currency market is better understood.