Question

Suppose that the Federal Reserve decided to adopt an easy money policy and cut the market interest rates in the U.S. What will happen to the U.S. dollar value in the foreign exchange market? Explain why.

Answer 1

When the Federal Reserve opts for a cut in the interest rates and a policy which relaxes the flow of money in the economy, it is primarily to come out of recession. Recently, this happened due to the Corona Virus Pandemic as demand has shrunk to all time low and the economy wants the support of the Federal Reserve for a kickstart.

In the international markets, prices of currencies are simply decided on the basis of demand and supply for the same. When the interest rates are lowered, and other policies such as open market operations in which the Federal Bank buys bonds and supplies money takes place, then the total flow of money or supply of money in the economy increases.

Further, the simple mathematics of demand and supply come into play. As the supply of dollar increases in the market, the end result is that the price for it internationally decreases and the overall exchange rate falls. This makes exports bring in relatively lesser value and imports become expensive for the United States.

We can thus conclude by the above discussion, that monetary policy easing leads to addition of money in the economy. This further creates a gap and the supply side increases. The end result is that the price of dollar in the international market goes down.

Please feel free to ask your doubts in the comments section if any.