Question

Suppose the markets change their expectations of the future value of the dollar, such that they expect it to be stronger at that time in the future than their expectation was previously (i.e., Ee decreases). a) How would this change in expectations affect spot exchange rates assuming interest rates stay constant? b) What would the central bank have to do to keep the spot rate from changing in the manner you described in part (a)?

Answer 1

If markets change their expectations about the future value of the dollar, and expect it to be stronger:

a) Investors will attempt to accumulate more dollars today, so that when the value of the dollar rises in the future, they can sell it and make a profit.

Due to this, the demand for dollars will rise in the present.

This will lead to an appreciation in the spot rate (i.e. the dollar becomes stronger today)

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b) Due to various reasons, the Central Bank may not want too much appreciation of the dollar.

To prevent this from happening, the Central Bank has a few options:

• to buy foreign currency and sell dollars in the international market
• to conduct expansionary monetary policy domestically, by lowering interest rates, or open market purchases, or printing more money

Either way, or using a combination of both, this will increase the supply of dollars.

Due to this, the value of dollars will fall. However, caution must be taken so that the depreciation is not very large.