For each of the following events draw a diagram of the foreign exchange market for dollars...

For each of the following events draw a diagram of the foreign exchange market for dollars in equilibrium, and show the effect on the demand curve and/or the supply curve of dollars as a result of each of the events. Does the dollar rise or fall in value?

i) Interest rates in the United States rise.

ii) Speculators become convinced that the future value of the Japanese yen will be higher relative to the dollar than it is today.

Expert Solution

1) When the interest rates increases, the money supply and the supply of dollars to foreign markets reduces. As a result the supply curve shifts leftward, indicating lesser supply of American dollars to the foreign market. The value for US dollars rises due to lesser supply of US dollars. This is the immediate effect in the foreign exchange market for dollars.

Eventually, due to high interest rates, many investors would want to hold US dollars and thus the demand for US dollars increases, and the US dollars will appreciate in value.

2) As speculators are confident enough that the value of yen is to appreciate in value in terms of US dollars, then they tend to hold more Japanese Yen than US dollars. As a result the demand for dollars decreases and so does it's value. This is the immediate effect. The demand curve shifts leftward, indicating reduced quantity of dollars demanded and decrease in exchange rate value of dollars.

Eventually the quantity supplied for dollars decreases due to the decrease in demand for dollars, and the value of dollars depreciates in the foreign exchange markets.

Rahul Sunny answered 2 years ago

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