Question

6. Holding the supply of dollar-denominated assets constant, what is the impact of the following changes on the dollar exchange rate, defined as the amount of other currencies a dollar can buy, with respect to other currencies? a) A rise in nominal domestic interest rates (5 points) rise in expected imp nport demand (5 points NOTE: Figures are needed!

Answer 1

Assuming dollar is the domestic currency.

The money supply is held constant for dollar- denominated asset.

So, Ms = constant.

Let Dollar exchange rate = e

A) Impact of rise in nominal domestic interest rates(i) on dollar exchange rate (e).

As i will increase, it will lead to a decrease in investment in the domestic market. This will increase the investment in foreign market. Thus, leading to an increase in supply of foreign exchange in the foreign country which will eventually decrease the dollar exchange rate. But since the supply of dollar denominated assets is constant, so this will lead to a situation of excess demand in the foreign market. The exchange rate will fall for a while to e' but will get back to e.

Excess DEMAND 0 QUANTITY DEMANDED SUPPLIED

As shown in figure, the supply increases from Ms to Ms' leading to a decrease in the exchange rate e from e to e'. But due to constant supply, there is a situation of excess demand GE'.

B) Impact of a rise in expected import demand (M) on the dollar exchange rate e.

As M will increase, it will lead to more demand of foreign exchange in the domestic country as the goods will cost cheaper of imported. This will shift demand curve to the right. As the supply of dollar denominated assets is constant so this will increase the dollar exchange rate e.

As shown in the figure, the demand increases from DD to DD' shifting the equilibrium from E to E'. Thus, increasing the exchange rate from e to e'.

QUANTITY DEMANDED SUPPLIED