1.Explain what would be the effect on the dollar/euro exchange rate if economicg
ID: 1096706 • Letter: 1
Question
1.Explain what would be the effect on the dollar/euro exchange rate if economicgrowth increased in the EMU but not in the United States.
2.Explain what would be the effect on the dollar/euro exchange rate if the pricelevel increased less in the United States than in the European Monetary Union(EMU).
3. Explain what would happen to the dollar/euro exchange rate if the interestrate increased in the United States but remained unchanged in the EuropeanMonetary Union (EMU).
4.(a) What is the absolute purchasing-power parity theory? Why is this notacceptable?(b) What is the relative purchasing-power parity theory? When do we expect itto hold?(c) Do empirical tests con?rm or reject the relative purchasing-power paritytheory?
Explanation / Answer
1.
When economic growth increases in EMU, it will lead to increased incomes in the hands of Europeans. As a result, Euro will appreciate.
2.
If the price level increased more in the EMU and less in US, it will lead to EU importing goods from US. As a result, EU imports will increase and US exports will increase. Thus, the Euro will appreciate and US$ will depreciate.
3.
If the interest rate increases more in US and remains unchanged in EMU, it will become more attractive for investors to invest money in US. As a result, demand for US$ will rise and the currency will thus appreciate.
4.
(a) Absolute purchasing power parity states that the exchange rate between two countries will be identical to the ratio of the price levels for those two countries.
(b) Relative purchasing power parity relates the changes in two countries’ expected inflation rates to the change in their exchange rates.
(c) Yes
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