Question

Imagine that at the same time GDP improves in the US, the European Central Bank (ECB) undertakes another round of quantitative easing, effectively increasing the foreign money supply. What would happen then to the expected foreign return? And to the current equilibrium exchange rate (E(t))? Please provide a short explanation and a graph.

Answer 1

Due to quantitative easing by the ECB, there is increase in foriegn money supply. This will cause the interest rate to fall in Europe. On the other hand an increase in GDP will tend to increase interest rates in the US. Thus rate of return will be relatively more in US and less in foreign as higher interest rates attract funds. Thus expected foreign return has decreased. The change in expected foreign return will affect both demand and supply of Dollars.

As rate of return is higher in the US, investors will demand for Dollars so that they can buy interest bearing assets which will provide relatively higher returns. At the same time the investors will not want to give away Dollars to the foreign exchange markets. Hence the demand for Dollars shift rightwards from D1 to D2 while supply of Dollars decreases and shifts leftwards from S1 to S2. This causes current equilibrium exchange rate to rise from E1 to E2. While quantity of Dollars remain the same.The demand side force increased quantity while the supply side force decreased the quantity.