Question

1) Suppose that the Fed decides to increase the growth rate of the money supply in the United States. What is most likely to happen to the U.S. trade deficit and to GDP?

Answer. The trade deficit will fall; GDP will rise

Please explain why?

2) Explain three factors that would cause the dollar to appreciate?

Answer 1

1.)when money supply increases in US, LM curve would shift to the right and IS curve would stay put. as a result , at the new equilibrium level interest rates would be lower and output will be high

also, when interest rates in US falls this will make foreign assets more attractive and this will lead to US dollar depreciation . thus, as a result of depreciation exports will increase and hence cause a fall in trade deficit in US.

2.)Factors that can cause a nation's currency to appreciate or depreciate include:

Relative Product Prices - If a country's goods are relatively cheap, foreigners will want to buy those goods. In order to buy those goods, they will need to buy the nation's currency. Countries with the lowest price levels will tend to have the strongest currencies (those currencies will be appreciating).

Monetary Policy - Countries with expansionary (easy) monetary policies will be increasing the supply of their currencies, which will cause the currency to depreciate. Those countries with restrictive (hard) monetary policies will be decreasing the supply of their currency and the currency should appreciate. Note that exchange rates involve the currencies of two countries. If a nation's central bank is pursuing an expansionary monetary policy while its trading partners are pursuing monetary policies that are even more expansionary, the currency of that nation is expected to appreciate relative to the currencies of its trading partners.

Inflation Rate Differences - Inflation (deflation) is associated with currency depreciation (appreciation). Suppose the price level increases by 40% in the U.S., while the price levels of its trading partners remain relatively stable. U.S. goods will seem very expensive to foreigners, while U.S. citizens will increase their purchase of relatively cheap foreign goods. The U.S. dollar will depreciate as a result. If the U.S. inflation rate is lower than that of its trading partners, the U.S. dollar is expected to appreciate. Note that exchange rate adjustments permit nations with relatively high inflation rates to maintain trade relations with countries that have low inflation rates.

Income Changes - Suppose that the income of a major trading partner with the U.S., such as Great Britain, greatly increases. Greater domestic income is associated with an increased consumption of imported goods. As British consumers purchase more U.S. goods, the quantity of U.S. dollars demanded will exceed the quantity supplied and the U.S. dollar will appreciate.