Question

a. Explain the short-run effects of contractionary monetary policy by the Fed on the dollar/euro exchange rate.

b. During periods of international geopolitical tension or economic crisis, there is often a “flight to quality.” In terms of the forex market, that basically means that investors rush to convert their assets into dollars, or dollar-denominated assets. Show the likely effect on the dollar/euro exchange rate.

Answer 1

Ans a) Short-run effects of contractionary monetary policy by the Fed on the dollar/euro exchange rate will be as under:

(i) The real money supply will be less than real money demand, the households and businesses will have less money to spend they would want to increase their short term liquidity to be more than their long term assets.

(ii) The drawl of money from long term to short term will create an Asset Liability mismatch for Banks / Financial Institutions which will raise the Interest rates on these long term deposits to make sure they have funds for lending long term loans.

(iii) This increased interest rates will lead to increase rate of return in the Forex market for the US Dollar. If we see currently US Fed interest rate is 2.50% whereas ECB interest rate is at 0.00%. Any sane person will invest in US Dollar rather than EURO leading an appreciation of US Dollar with respect to EURO due to Contractionary Monetary Policy.

Ans b) During "flight to quality" time as mentioned in the question that investors rush to convert their assets into dollars, or dollar-denominated assets. This means that demand for dollar has increased suddenly in the Forex Market as compared to Euro thus Dollar will appreciate as market is buying dollars and selling currencies like EURO. Remembering basic economics when demand for a commodity increases it appreciates that's what will happen in this case US dollar will appreciate with respect to EURO.