Question

2. For each of the below scenarios involving the euro and the dollar, one currency has an increase in supply, the other an increase in demand. Tell which. Be sure to include whether each currency rises or falls in value.           40 pts

More European tourists come to the US for vacations.

US interest rates fall significantly.

The euro increases in international acceptance as a currency of business.

The US economy outperforms most of the developed world.

Answer 1

a) More European tourists come to the US for vacations:

If more European tourists come to the US for vacations, then demand for US dollar will increase as tourists need to make payments in US dollars when they are in US. Supply of Euro will increase as European tourists will purchase dollar by paying in Euro.

Since demand for USD has increased, while at the same time supply of Euro has increased, this will cause increase in USD's value (appreciation) vis-a-vis Euro and a decrease in Euro's value (depreciation) vis-a-vis USD.

b) US interest rates fall significantly.

If US interest rates fall significantly, capital outflow will increase which will lead to an increased demand for Euro and an increased supply of USD.

Since demand for Euro has increased, and supply of USD has increased, this will cause increase in Euro's value (appreciation) vis-a-vis USD and a decrease in USD's value (depreciation) vis-a-vis Euro

c) The euro increases in international acceptance as a currency of business.

If euro increases in international acceptance as a currency of business, demand for euro will increase as people will want more euro because of its increased acceptance. At the same time, (some) people will want to dispose of USD who have kept it for international transactions or because of its general accepatibility. So supply of USD will increase.

Since demand for Euro has increased, and supply of USD has increased, this will cause increase in Euro's value (appreciation) vis-a-vis USD and a decrease in USD's value (depreciation) vis-a-vis Euro

d) The US economy outperforms most of the developed world.

If US economy outperforms most of the developed world, then its exports will increase, and there will be capital inflow due to increased production and possibility of higher returns. Both factors will cause demand for USD to increase. Due to capital outflows and increased imports in European countries, Euro's supply will increase.

Since demand for USD has increased, while at the same time, supply of Euro has increased, this will cause increase in USD's value (appreciation) vis-a-vis Euro and a decrease in Euro's value (depreciation) vis-a-vis USD.