Question

Use the market for foreign exchange to analyze the effect of the following events. In your graph, make sure to identify the effect of each of these events on the US dollar (i.e. does the dollar get weaker/stronger?) Explain in 1-2 sentences what each of your graphs is showing. Important: Treat each event separately (i.e. draw a separate graph for each event).

a. American companies discover a new technology that allows them to become much more productive.

b. The Central Bank of Canada decides to raise their interest rates.

Answer 1

Part A)

When American Companies increase their production due to a new technological advancement, the Aggregate Demand and Supply both increases. As a result, the demand for money in the economy also increases and so does the possibility of exports. For any economy which has a higher demand and supply, the currency rates become stronger. This can be explained with the help of the following graph: -

Here we see the exchange rate has been plotted on the Y axis and the Quantity has been plotted on the X axis. The Supply Curve changes to a higher quantity and the Demand for goods and services also changes. This happens as technological advancements increase the level of income and alters the demand and supply pattern. Accordingly, the Exchange rates increase from point P to P1 respectively.

Part B)

As the interest rates increase, the effect on exchange rates is similar. The level of activity in the economy gets a boost. This is because other countries expect better returns from their investments and accordingly shift their enterprises to these countries respectively. For example, if the interest rates get a boost, companies begin expanding to these countries as they are aware that the amount of money which they can earn simply by saving money is much higher than other counterparts and their return on investment would be higher. Though the same graph can be used to explained the effect, it has been redrawn so that the question can be answered.

Here we see that Interest Rates and exchange rates both get a boost and the Quantity Supplied in the country increases. This also changes the quantity demand.

We can conclude by saying, that as the interest rates are hiked, business owners have an increased incentive to invest in the countries which leads to an exchange rate hike at the same time.

It is important to note, that the Aggregate Supply Curve, is upward sloping as producers increase production with increased prices and better profits. The exact opposite happens for demand curve.

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