Suppose the European Central Bank decreases the growth rate of their money supply and the Federal...

Suppose the European Central Bank decreases the growth rate of their money supply and the Federal Reserve simultaneously decreases the growth rate of money supply as well. Working through the analytics involved explain the impact these policy interventions will have on the dollar-euro exchange rate.

Expert Solution

If the European Central Bank decreases the growth rate of their money supply then it is equivalent to contractionary monetary policy. Such a measure will cause the interest rate in the Euro zone to increase. This will happen because decline in the money supply will result in people withdrawing money out of their speculative balances to finance their transaction needs. To, maintain equilibrium in the money market of Euro zone, the interest rate will rise.

Rising interest rate will attract foreign capital inflow in the Euro zone, as investors will invest in Euro zone to take the advantage of higher interest rate.

Now, it is given that the Federal Reserve has also simultaneously decreased the growth rate of money supply as well. In such a situation interest rate in the US will also rise making US markets attractive for financial investors, thereby attracting capital inflow.

Now, the change in the dollar-euro exchange rate depends on the relative increase in the interest rate in the Euro zone and the US. If the interest rate in the Euro zone rises more than the interest rate in the US, then there will be capital inflow in the Euro zone and capital outflow from the US.

This means demand for Euro will rise and supply of dollar will increase. So, Euro will appreciate while the US dollar will depreciate.

Opposite will happen if the interest rate in the US rises more than the interest rate in the Euro zone.

Rahul Sunny answered 2 years ago

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