Chapter 16: 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

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In summary, when U.S. interest rates decline compared to the rest of the world, the demand for dollars is likely to decrease, the supply of dollars is likely to increase, and the exchange rate for dollars compared to euros is expected to weaken, resulting in the depreciation of the U.S. dollar against the euro. This occurs as investors seek higher returns in other countries, leading to fewer people wanting to invest in U.S. assets and more dollars being available in the foreign exchange market.

Step by step solution

Understand the relationship between interest rates and exchange rates

Lower interest rates in the U.S. make the U.S. assets relatively less attractive for investors compared to investments in other countries with higher interest rates. This can lead to a decrease in demand for dollars, as fewer people are interested in investing in U.S. assets.

Analyze the impact on the demand for dollars

As interest rates in the U.S. decrease compared to the rest of the world, the demand for dollars is likely to decline. Investors will prefer to invest in countries where they can earn a higher return on their investments, which will require converting their dollars to foreign currencies. This will cause the demand for dollars to decrease.

Analyze the impact on the supply of dollars

The supply of dollars in the foreign exchange market is likely to increase as U.S. interest rates decline. As investors seek higher returns in other countries, they will sell their U.S. assets and convert dollars to foreign currencies. This will lead to an increase in the supply of dollars in the exchange market, as more dollars are available for transaction.

Analyze the impact on the exchange rate for dollars compared to euros

The exchange rate between two currencies is determined by the supply and demand dynamics in the foreign exchange market. As the demand for dollars decreases and the supply of dollars increases due to the lower U.S. interest rates, the exchange rate for dollars compared to euros is expected to weaken. This means that the U.S. dollar will depreciate against the euro, meaning it will take more dollars to buy one euro. In conclusion, a decline in U.S. interest rates compared to the rest of the world is likely to result in a decrease in the demand for dollars, an increase in the supply of dollars, and a depreciation of the U.S. dollar in terms of the euro.

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