Question

1. Imagine France and the US are exclusive trading partners. French people can only use Euros while Americans can only use dollars. What happens to the exchange rate of either euros or dollars with the following changes? Explain carefully in a paragraph or two:
   1. US exporting industries become more productive.
   2. The French government doubles the money supply.
   3. The US government decides to increase their tariffs on delicious French Cheeses

Answer 1

Ans-a) If U.S exporting industries become more productive , it implies that there will be increased volume of exports by the country . Increase in exports would raise large revenue and result in inflow of funds in the country . Consequently , the demand for domestic currency will rise , thereby strengthening the Dollar. Hence , the US Dollar will appreciate in the foreign exchange market.

Ans-b) If the French government doubles the money supply , it would lead to inflation in the economy which makes the export good less competitve in the foreign market and hence the export demand would fall. Excess money supply also lowers the value of domestic currency . Inflation due to rush of money supply would decrease the interest rates , thereby decreasing the demand for domestic currency by investors. The combined effect of inflation, low interest rates and less competitve exports would lead to depreciation of French Euro in foreign exchange market.

Ans-c) Imposition of tariffs by US on French Cheese would lead to an appreciation of US Dollar and depreciation of French Euro . This is so because levying tariffs on French Cheese makes it expensive in U.S market . This would decrease the demand of French Cheese in US market and would also decrease the trade deficit of US with France . This terms of trade effect would result in appreciation of U.S Dollar.

However , the export demand of French Cheese has fallen leading to drop in revenue and inflow of funds . This decreases the demand for French Euro and hence cause a depreciation of French domestic currency.