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8. Balance of payments and the foreign exchange market The following graph shows the market for euros, which is initialy in equilibrium. Suppose an economic expansion in the United States leads to an increase in the incomes of American households, causing imports from Europe to rise On the graph, illustrate the effect of an economic expansion on the market for euros by shifting the appropriate curve or curves.

On the graph, illustrate the effect of an economic expansion on the market for euros by shifting the appropriate curve or curves. 3.5 Supp Demand 3.0 2.5 Supply 2.0 Flexible exchange rates 1.5 O 1.0 and Fixed exchange rates 0.5 14 16 QUANTITY OF EUROS (Billions)

On the graph, use the purple point (diamond symbol) to indicate the new equilibrium exchange rate and quantity under a system of flexible exchange Under a system of flexible exchange rates, the dollar will until the foreign exchange market reaches an equilibrium exchange rate of Now suppose that the United States wants to maintain the initial equilibrium exchange rate of $2 per euro. On the graph, use a grey point (star symbol) to indicate the new equilibrium under a system of fixed exchange rates. Under system of fixed exchange rates, which of the following policies could the U.S. government use to prevent the change in demand for euros from driving the exchange rate to the new equilibrium? Check all that apply. Lower interest rates by way of monetary policy Place import restrictions on European goods Sell u.s. euro reserves in the foreign exchange market

Under a system of flexible exchange rates, the dollar will until the foreign exchange market reaches an equilibrium exchange rate of depreciate Now suppose that the United States wants to maintain th appreciate brium exchange rate of $2 per euro

On the graph, use the purple point (diamond symbol) to indicate the new equilibrium exchange rate and quantity under a system of flexible exchange rates. Under a system of flexible exchange rates, the dollar will until the foreign exchange market reaches an equilibrium exchange rate of $1.5 per euro $2 per euro $2.5 per euro e a grey point (star symbol) to indicate the new equilibrium under a system of fixed exchange rates the United States wants to maintain the initial equilibrium exchange rate of $2 per euro

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Answer #1

PxeTo maintain the exchange rate from driving to the new equilibrium level,

Option c - sell US euro reserves in the foreign exchange market.

Reason : If the government uses euro reserves to buy back dollars, it will increase the value of dollar.

On the other hand, lowering interest rate will lead to increase in money supply which would further depreciate dollar. As increasing money supply will only raise euro demand.

Also, import restrictions will only raise the euro currency value and not decrease it. (Look at graph).

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