Question

An article in the Wall Street Journal stated: The U.S. dollar's more than \(20 \%\) rally since 2014 has been driven largely by what analyst call "divergence." While the Fed has been slowly tightening monetary policy amid an improving [U.S.] economy, central banks in Europe and Japan have continued to introduce stimulus as they struggle with stagnant growth and very low inflation. a. Which economic variable is "diverging" because of differences between the monetary policy of the Fed on the one hand and the monetary policies of the central banks of Europe and Japan on the other hand? b. Draw a graph of the demand and supply of U.S. dollars and show the effect of this "divergence" on the foreign exchange value of the dollar. Briefly explain what is happening in your graph.

Short answer

The diverging economic variable due to different monetary policies is the value of the US dollar in foreign exchange markets. The divergence or differences in monetary policy cause an increase in demand for USD, leading to an increase in its value in foreign exchange markets. This is illustrated in a graph of the supply and demand of USD, where the tightening of monetary policy by the Federal Reserve leads to a shift to the right in the demand curve, thereby raising the equilibrium value of the dollar.

Step-by-step solution

Identifying the diverging economic variable

The diverging economic variable in this context is the Value of the US Dollar in foreign exchange markets. It's diverging because while the Fed has been tightening monetary policy leading to a stronger USD, central banks in Europe and Japan are introducing stimulus thereby weakening their respective currencies.

Drawing the graph

A graph representing the supply and demand of USD in foreign exchange markets would typically have 'Quantity of USD' on the x-axis and 'Value of USD' on the y-axis. The demand curve would be downwards sloping indicating that as the value of USD increases, its demand decreases and vice-versa. The supply curve would be upwards sloping indicating that as the value of USD increases, its supply also increases and vice-versa.

Showing the effect of divergence

This divergence has caused a shift to the right in the demand curve for USD as the tightening of monetary policy by the Fed makes USD more attractive on the foreign exchange market. This rightward shift increases the equilibrium value of the USD. This should be represented on the graph as a shift from the original demand curve (D1) to the new demand curve (D2) leading to an increase in the equilibrium value from P1 to P2.

Explaining the graph

The graph shows how the divergence in monetary policy is causing the demand for USD to increase, as indicated by the shift in the demand curve. This is mainly due to the tightening monetary policy of the Fed, which makes USD more attractive. This increased demand raises the equilibrium value of USD in foreign exchange markets, as illustrated by the increase in value from P1 to P2 on the graph.

Key concepts

Monetary Policy

Monetary policy plays a crucial role in determining a country's currency value in the foreign exchange markets. It involves the actions taken by a nation's central bank to control the money supply, influence economic activity, and ensure economic stability.

• When a central bank, like the U.S. Federal Reserve, tightens monetary policy, it typically raises interest rates. This makes investments in the country's financial instruments more attractive due to higher returns. Consequently, demand for the currency increases, strengthening its value.
• Conversely, if central banks, such as those in Europe and Japan, loosen monetary policy by lowering interest rates or implementing stimulus measures, their currencies may weaken. Lower interest rates mean lower returns on investments, decreasing demand for those currencies.

The divergence in these policies can lead to significant changes in currency values, as seen in the appreciation of the U.S. dollar when compared to other major currencies.

Demand and Supply Curves

In the context of foreign exchange markets, the demand and supply curves illustrate how the U.S. dollar's value is determined based on its demand and supply.

Typically, the demand curve for the U.S. dollar is downward sloping, meaning that as the value of the dollar increases (making it more expensive), fewer people are willing to buy it. On the other hand, the supply curve is upward sloping, indicating that as the dollar's value increases, holders are more willing to sell due to the higher price they can receive.

In the scenario described, a tightening of the U.S. monetary policy led to a shift in the demand curve for the dollar. As investors found U.S. financial assets more attractive, the demand for dollars surged, resulting in a rightward shift of the demand curve. This increase in demand elevates the equilibrium value of the dollar in the exchange markets.

Currency Valuation

Currency valuation is the process of determining the worth of one currency in relation to another. It's influenced by several factors including economic conditions, political stability, and importantly, monetary policy.

• Divergent monetary policies, as in the case of the Fed versus European and Japanese central banks, can have profound effects on currency valuation. When the Fed tightens monetary policy, it shores up investor confidence, pushing the value of the dollar upwards.
• Meanwhile, expansionary policies in Europe and Japan imply lower returns on investments in those regions, reducing their currency value. Investors tend to shift their portfolio towards U.S. dollars, further increasing its value.

This dynamic reinforces how crucial monetary policy is in influencing currency valuation in foreign exchange markets. A stronger dollar increases purchasing power for U.S. consumers but can make American exports more expensive abroad, affecting international trade dynamics.