Question

How would each of the following developments affect the exchange rate of the US dollar (state whether the US dollar will get stronger or weaker)? Support your answer discussing the effects on the demand and supply of a foreign currency or dollars and using appropriate diagrams.

a. Increase in the expected inflation rate in the economies of US trading partners

b. Increase in the expected future exchange rate (US $ is expected to grow stronger)

c. Americans are traveling less abroad because of the Covid 19 situation

d. The European Union interest rate rises relative to the US interest rate

e. Less foreign tourists are coming to the Florida beach for fear of covid 19.

Answer 1

In each graph, exchange rate (P) and quantity of dollars (Q) are shown along vertical and horizontal axis, respectively. D0 and S0 are initial demand and supply of dollar, intersecting at point A with initial exchange rate P1 and quantity of dollar Q1.

(a)

Higher inflation rate in trading partners will increase US export demand, which will increase the demand for dollar. The demand curve for dollar shifts rightward to D1. Exchange rate will increase, appreciating dollar.

In following graph, D0 shifts right to D1, intersecting S0 at point B with higher exchange rate P1 and higher quantity of dollar Q1.

(b)

If dollar is expected to grow stronger, currency speculators will buy more dollar now, so this will increase the demand for dollar. The demand curve for dollar shifts rightward to D1. Exchange rate will increase, appreciating dollar.

In following graph, D0 shifts right to D1, intersecting S0 at point B with higher exchange rate P1 and higher quantity of dollar Q1.

(c)

Less US travel abroad will decrease the demand for foreign currency and decrease the supply of dollar. The supply curve for dollar shifts leftward to D1. Exchange rate will increase, appreciating dollar.

In following graph, S0 shifts left to S1, intersecting D0 at point B with higher exchange rate P1 and lower quantity of dollar Q1.

(d)

Higher interest rate in EU will decrease foreign investment in US. Demand for dollar will decrease, shifting dollar demand curve to left and decreasing both exchange rate and quantity of dollars. At the same time, more Americans will sell dollar to buy euro for investing, so supply of dollar will increase, shifting dollar supply curve to right and decreasing exchange rate while increasing the quantity of dollars. The net effect is a definite decrease (depreciation) in dollar exchange rate, but effect on quantity is uncertain.

In following graph, D0 shifts left to D1 and S0 shifts right to right, intersecting at point B with lower exchange rate P1 and new quantity of dollar Q1.

(e)

Less tourists coming to US will decrease the dmand for dollar, shifting dollar demand curve to left and decreasing both exchange rate and quantity of dollars. Exchange rate will decrease, depreciating dollar.

In following graph, D0 shifts left to D1, intersecting S0 at point B with lower exchange rate P1 and lower quantity of dollar Q1.