Question

Question 2: Assume that the current exchange rate is set at $1.80 = £1.00. Fed just increased the interest rate in US. Draw demand and supply curve to show the new exchange rate in equilibrium. (9 points) Sollarprice per pound (exchange rate)

Answer 1

Dollar pnce pound (exchange rate

Since interest rates increased in the United States as compared with England. So, the financial investments in the US promise a higher return than they previously did. As a result, more investors will demand US dollars so that they can buy interest-bearing assets and fewer investors will be willing to supply US dollars to foreign exchange markets. Demand for the U.S. dollar will increase, and supply will fall. Here, since pound is the base currency, the supply and demand will be seen from pond's perspective. If demand for US dollar increases, that means demand for Pound relatively declined. So the demand curve will move left wards from DO to D1. Similarly, If supply for US dollar declined, that means supply of Pound relatively increased. So the supply curve will move right wards from SO to Si. The equilibrium (exchange rate) will move from EO to E1. Dollar has strengthen as compared to Pound, or Pound has weakened as compared tp Dollar.