Chapter 43, Problem 2FRQ

a)

To determine

To find: Equilibrium in the foreign exchange market.

Explanation of Solution

  

Economics Concept Introduction

Introduction: Exchange rate refers to the rate of conversion of one currency into another. This is usually determined for the trading of goods and services with one country and the rest of the world.

b)

To determine

To find: The impact on country U interest rate and international capital flows due to monetary policy.

Explanation of Solution

If Fed follows an expansionary monetary policy, the money supply will increase which causes the interest rate to fall. This makes us a less attractive destination for investment, reducing international capital inflow to the country U.

Economics Concept Introduction

Introduction: Exchange rate refers to the rate of conversion of one currency into another. This is usually determined for the trading of goods and services with one country and the rest of the world.

c)

To determine

To draw: Graphical representation of foreign exchange rate showing the effect of the Fed’s policy.

Explanation of Solution

Demand for the US dollar decreases. Also with a lower interest rate in country U, country U’s investors may invest more abroad which increases US dollar supply.

Demand curve shifts left, hence, the supply curve will shift right, leading to a decrease in e (depreciation of USD) (Point E₁ in the diagram).

Economics Concept Introduction

Introduction: Exchange rate refers to the rate of conversion of one currency into another. This is usually determined for the trading of goods and services with one country and the rest of the world.

d)

To determine

To find: Affect on country U aggregate demand due to Fed’

Explanation of Solution

Fed monetary policy changes interest rates which directly affect consumption and investment expenditure. Also, exchange rate changes (on account of change in interest rate) change aggregate demand through Net exports.

Economics Concept Introduction

Introduction:

Exchange rate is the rate of conversion of one currency into another. This is usually determined for the trading of goods and services with one country and the rest of the world.