Chapter 29: Problem 3

Suppose U.S. interest rates decline compared to the rest of the world. What would be the likely impact on the demand for dollars, supply of dollars, and exchange rate for dollars compared to, say, euros?

Short Answer

Expert verified

In conclusion, a decline in U.S. interest rates compared to the rest of the world could lead to a decrease in demand for dollars and an increase in the supply of dollars. Together, these effects would likely result in a decrease in the exchange rate for dollars compared to other currencies, such as euros.

Step by step solution

Determine the effect of a decline in interest rates on the demand for dollars

When U.S. interest rates decline relative to the rest of the world, investors will find holding U.S. assets, such as stocks or bonds, less attractive. This is because lower interest rates mean lower returns on investments. As a result, investors may prefer to invest in assets from other countries, which would lead to a decrease in demand for U.S. dollars.

Determine the impact of a decline in interest rates on the supply of dollars

A decline in U.S. interest rates could also have an effect on the supply of dollars. If U.S. interest rates are lower than those of other countries, U.S. investors may also find foreign assets to be more attractive than domestic assets. In order to purchase those foreign assets, U.S. investors would need to exchange their dollars for foreign currencies (e.g., euros), thereby increasing the supply of dollars in the foreign exchange market.

Analyzing the combined impact on the demand and supply of dollars

The decrease in the demand for dollars together with the increase in the supply of dollars should lead to a decrease in the value of the U.S. dollar compared to foreign currencies. In other words, the exchange rate for dollars to euros should decrease.

Conclusion

In conclusion, a decline in U.S. interest rates compared to the rest of the world could have a negative impact on the value of the U.S. dollar. This is because the decrease in U.S. interest rates would likely lead to a decrease in demand for dollars and an increase in the supply of dollars in the foreign exchange market. As a result, the exchange rate for dollars compared to other currencies, such as euros, would be expected to decline.

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