For this question, assume that exchange rates are flexible and that the exchange

Question

For this question, assume that exchange rates are flexible and that the exchange rate expected to occur in one year is NOT constant. Suppose that individuals now expect that the foreign central bank will pursue expansionary monetary policy in one year. This expected future monetary expansion by the foreign central bank will cause which of the following to occur?

a. the current nominal exchange rate will not change.

b. the current nominal exchange rate will decrease.

c. the current nominal exchange rate will increase.

d. the effects on the current nominal exchange rate are ambiguous.

Explanation / Answer

Option (c).

An expected monetary expansion by foreign central bank will mean that the foreign central bank will increase its domestic mone supply, which will lead to a decrease in foreign interest rate, making the foreign country a less attractive investment destination. Demand for foreign currency will decrease, making the foreign currency depreciate relative to domestic currency, and the domestic currency appreciate related to foreign currency. This will increase the current nominal exchange rate.

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