Question

Using the concept of "carry trade," explain how a decrease in U.S. interest rates could affect the EUR/USD exchange rate. Given this change in exchange rate, how would firms and customers be affected?

Answer 1

Carry Trade is a trading strategy, which means the investor sell the asset, which has low interest rate and borrow the assetts which has high interest rate.Carry trading is the most simple strategies for currency trading, In the case of currency market carry trade means borrow the high-interest currency instead of the low-interest currency.

The decrease in U.S interest rates could affect the EUR/USD exchange rate.the carry trading exchange rate of the low-interest-rate currency fall relative to the other.So here the decrease in US interest rate lead to low exchange rate of US doller relative to European EUR.And decrease in U.S. interest rates will reduce the rate of return from dollars than the rate of return from pounds, which will lead to do more investments in European assets with investors, and this will result in an increase in the USD/EURO exchange rate that means a depreciation of the U.S. dollar and an appreciation of the European currency.And vice versa.This will shows in the attached figure. there is decrease the US interest rate from Io to I1, then rate of return reduce from Ro to R1 and increase the exchange rate from Eo to E1.that means the depreciation of USD occured over EURO.

Currency depreciation usually increases inflation because imports become costly and the higher the prices lead to higher inflation. It makes imports less attractive, causing the demand for local products to rise.So that here Dollar depreciation occured so rising inflation in US due to us import is costly and the higher the price of foreign (european)product, makes the redumption of import therefore the demand for US product will rise. Firms have to increase their cost to improve production and meet the increasing demand of the domestic product.