Question

3. The FED is worried that the value of the U.S. dollar will continue to rise relative to the EU euro in 2018. So it is looking to reduce interest rates.

a. Explain what actions it is likely to take using macroeconomic measurements and models and analyze what is likely to happen to U.S. GDP and inflation.

b. Use macro models and macro movement sequences to explain two “risks” to the U.S. economy that could hamper the effectiveness of the monetary policy in 2018-2019.

Answer 1

3a. Since the aim is to try and reduce the appreciation of the US dollar, the Fed will seek to use a expansionery monetary policy that will keep interest rates low. Thus it will undertake a open market purchase of bonds that will release money supply into the economy and so reduce interest rates. This reduces the demand for the US currency and so the currency will depreciate as the interest rate falls. This in turn has an effect of improving the balance of payments as exports rise and imports fall. The Lm curve will thus shift rightwards in the ISLm model and this reduces interest rates and increases the output level.With the new monetary policy the consumption and investment will increase and so this raises inflation levels in the long run. The Fed can also reduce the discount rate and discourage investment in the US economy and so this reduces the demand for the US dollar and so the dollar will stop appreciating. US GDP rises and so does inflation.

b. The change in the exchange rate can be effected by exchange rate risk which causes the fluctuation of the change in the currency such as the euro which hampers the effectiveness of the policy. Also the time lag will have an impact on how well the policy works. It will take some time for the fall in the demand for the dollar to occur in response to the fall in the interest rates. The changes in the inflation rates and the rate of growth of incomes will also determine how well the policy works in bringing down the demand for the domestic currency.