Let the exchange rate be defined as the number of dollars per British pound. Ass
ID: 1230756 • Letter: L
Question
Let the exchange rate be defined as the number of dollars per British pound. Assume there is a relatively lower rate of inflation in U.S. relative to that of Britain.(a.) Would this event cause the demand for the dollar to increase or decrease relative to the demand for the pound? Why?
(b.) Has the dollar appreciated or depreciated in value relative to the pound?
(c.) Does this change in the value of the dollar make imports cheaper or more expensive for Americans? Are American exports cheaper or more expensive for importers of U.S. goods in Great Britain? Illustrate by showing the price of a U.S. cell phone in Britain,before and after the change in the exchange rate.
(d.) If you had a business exporting goods to Britain, and U.S. inflation fell as discussed above in this example, would you plan to expand production or cut back? Why?
Explanation / Answer
The demand for the dollar would decrease, as the decrease in relative interest rates means that foreign investors will be less willing to invest their capital in US institutions, as their return on their investments will decrease. Since they are likely to either avoid investing in US institutions or to pull their capital out, they will seek to exchange their capital to the British Pound which is doing relatively better and offers more suitable interest rates, which means that the international supply of the US dollar increases, subsequently lowering its relative price. This means that the dollar depreciates in value relative to the Pound Since the dollar is weak in comparison to other currencies, the purchasing power of other currencies in relation to the US dollar increases, meaning consumers and investors are able to purchase more US dollars relative to the amount they spend. This means that the demand of US made goods increases, which is beneficial for US exporters and domestic producers as their products become relatively cheaper than imported goods. This means a US made cellphone before the interest rate decrease may have cost £100, after the interest rate decrease it would decrease in price for British consumers to maybe £90. If you had an exporting business to Britain, you would expand production, as there is potential for high growth in these industries since demand is high (look at the Chinese economy and how it has boomed, in relation to the exchange rate manipulation of the Yuan by the Chinese government to artificially depreciate the currency)
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