Question

Explain how the following factors affect the dollar's exchange rate under a system of market-determined exchange rates: (a) a rise in the U.S. price level, with the foreign price level held constant; (b) tariffs and quotas placed on U.S. imports; (c) increased demand for U.S. exports and decreased U.S. demand for imports; (d) rising productivity in the United States relative to other countries; (e) rising real interest rates overseas, relative to U.S. rates; (f) an increase in U.S. money growth; and (g) an increase in U.S. money demand.

Short answer

Higher U.S. price levels or increase in overseas real interest rates can lead to depreciation of the U.S. dollar, while tariffs on imports, increased demand for exports, decreased demand for imports, rising productivity, or increase in U.S. money demand can lead to the dollar’s appreciation. An increase in U.S. money growth could either appreciate or depreciate the dollar depending on the rate of inflation.

Step-by-step solution

Impact of Rising U.S. Price Level

If the U.S. price level increases while the foreign price level remains the same, it results in imported goods becoming relatively cheaper. This increases the demand for foreign currency, reducing the demand for the U.S. dollar, and leading to its depreciation.

Impact of Tariffs and Quotas on U.S. Imports

Tariffs and quotas on imports make imported goods more expensive. This discourages import, reducing the demand for foreign currency and increasing the demand for the U.S. dollar, leading to its appreciation.

Impact of Changes in Export and Import Demand

Increased demand for U.S. exports and decreased U.S. demand for imports leads to a higher demand for the U.S. dollar and lower supply of it in the foreign exchange market. This causes the U.S. dollar to appreciate.

Impact of Rising Productivity in the U.S.

Rising productivity in the U.S. leads to a decrease in the price of goods and makes U.S. goods more attractive in the international market, increasing the demand for the U.S. dollar and causing it to appreciate.

Impact of Rising Real Interest Rates Overseas

If real interest rates are higher overseas compared to U.S. rates, it would attract investment away from the U.S. towards other countries. This would increase the demand for foreign currency and decrease the demand for the U.S. dollar, leading to its depreciation.

Impact of Increase in U.S. Money Growth

An increase in U.S. money growth generally leads to inflation. If U.S. inflation exceeds that of other countries, this could lead to a depreciation in the U.S. dollar as the demand for foreign currency increases because foreign goods become relatively cheaper.

Impact of Increase in U.S. Money Demand

If there is an increase in U.S. money demand, the demand for the U.S. dollar increases, causing it to appreciate.

Key concepts

Inflation

Inflation refers to the rate at which the general level of prices for goods and services rises, eroding the purchasing power of a currency.
It plays a critical role in determining exchange rates in the global economy.
If the U.S. price level increases while the foreign price level stays constant, U.S. goods become relatively more expensive.
Consequently, imported goods become cheaper, increasing the demand for foreign currency. This leads to a decrease in demand for the U.S. dollar, causing it to depreciate.

• Inflation erodes purchasing power.
• High inflation in the U.S. makes domestic goods cost more than foreign goods.
• This increases demand for foreign currencies, thereby depreciating the U.S. dollar.

Trade Policy

Trade policies like tariffs and quotas can significantly affect a country's exchange rates.
Tariffs and quotas on U.S. imports make foreign goods more expensive, discouraging imports and reducing the need for foreign currencies.
This in turn increases the demand for the U.S. dollar, causing it to appreciate.

• Trade policies impact exchange rates by influencing import and export dynamics.
• Tariffs and quotas raise the cost of foreign goods, thus reducing imports.
• Decreased imports lower foreign currency demand and inflate U.S. dollar value.

Foreign Exchange Market

The foreign exchange market (Forex) is where currencies are traded, and it plays a crucial role in determining exchange rates.
Factors like changes in export and import demands directly impact the supply and demand for currencies.
If there is an increased demand for U.S. exports and decreased demand for imports, the resulting higher demand for the U.S. dollar can cause it to appreciate.

• Forex is vital for currency trading and exchange rate determination.
• Demand dynamics in this market can make a currency appreciate or depreciate.
• Increased U.S. export demand bolsters the dollar through higher demand.

Interest Rates

Interest rates, the cost of borrowing money, are a powerful tool in economic policy.
They influence exchange rates by affecting currency attractiveness to foreign investors.
If real interest rates rise overseas relative to the U.S., investors might shift their funds to gain better returns, leading to increased demand for foreign currencies and depreciation of the U.S. dollar.

• Interest rates inform investors' decisions, impacting exchange rates.
• Higher foreign interest rates attract investment away from the U.S.
• This increases foreign currency demand and weakens the U.S. dollar.

Productivity

Productivity, the efficiency of production, is a key determinant of a country's economic health and competitiveness.
Rising productivity in the U.S. often leads to lower production costs and more competitive pricing of goods.
This makes U.S. products more attractive globally, boosting demand for the dollar and causing it to appreciate.

• Productivity enhances economic competitiveness, affecting currency value.
• More efficient production reduces costs and prices.
• This increases international demand for goods and the U.S. dollar.