Question

Part 1

The United States' economy is growing at a faster rate than the economy of its trading partner, the United Kingdom. As a result, the rate of American inflation is increasing.

1. Draw correctly labeled graphs to show how the increase in inflation will affect the supply of the U.S. dollar and demand for the British pound in the foreign exchange market.
2. Based on the scenario, what will happen to the value of the U.S. dollar? Explain. (Make sure you use the costs of foreign and domestic goods in your explanation.)
3. Based on the changing value of the U.S. dollar in part (B), how will U.S. net exports be affected? Explain.

Part 2

The Federal Reserve decreases the money supply in the United States causing interest rates to increase.

1. Draw correctly labeled graphs to show how the increased interest rates in the scenario will affect the demand for the U.S. dollar and supply of the EU euro in the foreign exchange market.
2. Based on the scenario, what will happen to the value of the EU euro? Explain. (Make sure you use the concept of foreign financial investment in your explanation.)
3. Based on the changing value of the EU euro in part (B), how would U.S. aggregate demand be affected? Explain.

Answer 1

Part-1

1.Unites state's economy is growing at a faster rate than the economy of its trading partner, United Kingdom. As a result, rate of inflation in America is increasing. If exchange rate is considered as dollar price of British pound, inflation will increase the supply of U. S. dollar in foreign exchange market. It will increase the price of dollar in terms of pound. It means exchange rate of dollar will increase. If exchange rate of British pound price of dollar is considered, inflation in America leads to increase in demand for British pound will increase. It will decrease the price of British pound in terms of U. S. dollar. That means exchange rate of British pound will decline.

2.Due to higher supply of U. S. dollar, exchange rate of dollar interms of British pound will increase. It will reduce the value of U. S dollar. It results depreciation of U. S. dollar in foreign exchange market. It will make U.S.goods cheaper and foreign goods highly expensive.

3.Depreciation of U.S. dollar will reduce the consumption of foreign goods . Because US goods become cheaper and foreign goods become expensive. It will increase the exports and decrease the imports of foreign goods. It increase the net exports of US economy

Part-2

1. The Federal Reserve decreases the money supply in the United States causing interest rate to increase. Increase in interest reduces the money supply in the economy. As a result price inflation will decrease in U.S.economy. It rises capital inflows to U. S. because higher interest rate attract investors from European union. As far as exchange rate between dollar and euro concerned, higher interest rate results increase in demand for U. S. dollar and supply of euro.

2.Increase in supply of euro reduces the value of euro in foreign exchange market. It will depreciate euro.

3. Depreciation of euro makes European Union goods cheaper and U. S goods expensive.  
Therefore it will increase imports and decrease the exports of U. S. economy. Thereby net exports of U. S. will decline. As a result aggregate demand for U. S. goods and services will decline.