The exchange rate between Pounds and US dollars is determined by the intersection of the demand...

The exchange rate between Pounds and US dollars is determined by the intersection of the demand and supply curves for euros in terms of dollars. Explain how an increase in US inflation relative to English inflation will effect equilibrium exchange rates.

Expert Solution

Inflation rates can affect the exchange rate between the two countries. If the inflation increases in the US relative to England, the US goods will become less competitive in the international goods market as their prices have now increased. Foreigners will find it difficult to purchase US goods and thus, the demand for US Dollar will go down (you need to pay for US goods in US dollars). Thus, the demand for dollar shifts tot he left and the value of dollar falls i.e. the USD will depreciate in relation to the English Pound. This is in line with the Purchasing power parity theory which states that purchasing power across nations must be the same. (Depreciating dollars compensates for the increase in prices of US goods)

Rahul Sunny answered 2 years ago

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what is exchange rate and factors that determines demand for exchange rate

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