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Chapter 29: Problem 10

An article in the Wall Street Journal stated: The U.S. dollar's more than \(20 \%\) rally since 2014 has been driven largely by what analyst call "divergence." While the Fed has been slowly tightening monetary policy amid an improving [U.S.] economy, central banks in Europe and Japan have continued to introduce stimulus as they struggle with stagnant growth and very low inflation. a. Which economic variable is "diverging" because of differences between the monetary policy of the Fed on the one hand and the monetary policies of the central banks of Europe and Japan on the other hand? b. Draw a graph of the demand and supply of U.S. dollars and show the effect of this "divergence" on the foreign exchange value of the dollar. Briefly explain what is happening in your graph.

Short Answer

Expert verified
The diverging economic variable due to different monetary policies is the value of the US dollar in foreign exchange markets. The divergence or differences in monetary policy cause an increase in demand for USD, leading to an increase in its value in foreign exchange markets. This is illustrated in a graph of the supply and demand of USD, where the tightening of monetary policy by the Federal Reserve leads to a shift to the right in the demand curve, thereby raising the equilibrium value of the dollar.

Step by step solution

01

Identifying the diverging economic variable

The diverging economic variable in this context is the Value of the US Dollar in foreign exchange markets. It's diverging because while the Fed has been tightening monetary policy leading to a stronger USD, central banks in Europe and Japan are introducing stimulus thereby weakening their respective currencies.
02

Drawing the graph

A graph representing the supply and demand of USD in foreign exchange markets would typically have 'Quantity of USD' on the x-axis and 'Value of USD' on the y-axis. The demand curve would be downwards sloping indicating that as the value of USD increases, its demand decreases and vice-versa. The supply curve would be upwards sloping indicating that as the value of USD increases, its supply also increases and vice-versa.
03

Showing the effect of divergence

This divergence has caused a shift to the right in the demand curve for USD as the tightening of monetary policy by the Fed makes USD more attractive on the foreign exchange market. This rightward shift increases the equilibrium value of the USD. This should be represented on the graph as a shift from the original demand curve (D1) to the new demand curve (D2) leading to an increase in the equilibrium value from P1 to P2.
04

Explaining the graph

The graph shows how the divergence in monetary policy is causing the demand for USD to increase, as indicated by the shift in the demand curve. This is mainly due to the tightening monetary policy of the Fed, which makes USD more attractive. This increased demand raises the equilibrium value of USD in foreign exchange markets, as illustrated by the increase in value from P1 to P2 on the graph.

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Most popular questions from this chapter

Briefly explain whether you agree with the following statement: "Because in 2016 national saving was a larger percentage of GDP in the United States than in the United Kingdom, domestic investment must also have been a larger percentage of GDP in the United States than in the United Kingdom."

What are the three main sets of factors that cause the supply and demand curves in the foreign exchange market to shift?

If a country saves more than it invests domestically, what must be true of its net foreign investment?

Look again at Solved Problem \(29.3,\) where the saving and investment equation \(S=I+N X\) is derived. In deriving this equation, we assumed that national income was equal to \(Y\). But \(Y\) only includes income earned by households. In the modern U.S. economy, households receive substantial transfer payments-such as Social Security payments and unemployment insurance paymentsfrom the government. Suppose that we define national income as being equal to \(Y+T R,\) where \(T R\) equals government transfer payments, and we also define government spending as being equal to \(G+T R\). Show that after making these adjustments, we end up with the same saving and investment equation.

If we know the exchange rate between Country A's currency and Country B's currency and we know the exchange rate between Country B's currency and Country Cs currency, then we can compute the exchange rate between Country A's currency and Country C's currency. a. Suppose the exchange rate between the Japanese yen and the U.S. dollar is currently \(¥ 115=\$ 1\) and the exchange rate between the British pound and the U.S. dollar is \(£ 0.75=\$ 1 .\) What is the exchange rate between the yen and the pound? b. Suppose the exchange rate between the yen and the dollar changes to \(¥ 120=\$ 1\) and the exchange rate between the pound and the dollar changes to \(£ 0.70=\$ 1\). Has the dollar appreciated or depreciated against the yen? Has the dollar appreciated or depreciated against the pound? Has the yen appreciated or depreciated against the pound?
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