Question

The Federal Reserve on Tuesday, March 3, 2020 took the emergency step of cutting the benchmark U.S. interest rate by half a percentage point, an attempt to limit the economic and financial fallout from the coronavirus. Consider the FX market and the money market diagrams we learned within asset approach to exchange rate determination and answer the following questions. Let US be the home country and Euro Area be the foreign country. a) Following the Fed’s decision, explain which schedule(s) shift in the US money market and why. b) Following the Fed’s decision, explain which schedule(s) shift in the FX market and why. c) What happens to the equilibrium E$/€ exchange rate? Why?

Answer 1

A) lower interest rate will induce aggregate demand made in US. Consumers, firms and even exporters will borrow more and consumes and invests more. There will be increase in demand for currency. Demand curve shifts to right hand side. Lower interest will decrease exchange rate. This will increase export of US as export price is becoming cheaper. Increases GDP and employment in the country.

B) When there is cut in interest rate, return from investing in US is getting decreased. So demand for US dollars will get decreased. Demand for Euro will get increased due to cut in interest rate in US in short run. This will shift the demand curve of Euro to right hand side. People may believe Euro is stringer. Because of it itself demand curve will further shifts to right hand side. As investing in European Union now gain more returns, supplier will be hesitant to supply Euro. So supply curve of Euro will shift to left hand side.

C) The above stated reasons will increase exchange rate of Euro in terms of US dollars without changing quantity demanded and supplied of Euros. But in long run, European Area can have inflation as it attracts more and more of foreign money. This will reduce its value. Exchange rate may get decreased for Euro in terms of US dollars.