Question

1. Due to the recent Brexit vote, the British pound and Euro have both depreciated relative to the dollar, how does this impact exports and imports, AD and GDP? What should the Fed. due to respond? (20 points)

2. What happens to the value of the dollar if the European Central Bank (ECB) does quantitative tightening to the money supply? How will this impact the value of the dollar, exports and imports, AD and GDP? (20)

Answer 1

1. When the dollar appreciates against major foreign currencies, one generally expects to see current-dollar exports decrease, as U.S. produced goods become expensive abroad.  The effect on current-dollar imports is more ambiguous:  Appreciation decreases the dollar cost of a given volume of imports, but the volume may decline to the extent that domestic goods and services are substituted for imports in response to the increase in the relative cost of purchases from abroad.

Assuming that the export stimulus effect and the volume effect on imports together outweigh the import-cost effect, dollar appreciation would be expected to decrease U.S. competiveness, an decrease in net exports, and a corresponding decrease in GDP.

Agreegate Demand = C+G + I + (Export - Import).

Import increase relative to exports, inturn decreasing GDP, however US GDP is on an average is 70% driven by personal consumption expenditure.

The Fed keeps interest rates low because a lower federal funds rate supports business expansions, which leads to more jobs and higher consumption. This has all worked to keep appreciation of the U.S. dollar low.

2. Quantitative tightening will appreciate Euro and all other factors constant will depreciate dollar.

dollar depreciation will lead to increases in U.S.-based production as domestically produced goods are substituted for imported goods.  This would lead to an increase in real GDP and a decrease in real imports.  Dollar depreciation may also lead to an increase in U.S.-based production for export, as foreigners substitute “cheaper” U.S. goods for goods produced in their own countries.  This added production would also lead to an increase in real GDP.  The ultimate effect, however, of dollar depreciation on GDP depends on many factors, including the extent to which other countries adjust their own currencies in response to dollar depreciation.