Question

If expected inflation drops in Europe, so that interest rates fall there, what will happen to the exchange rate on the U.S. dollar?

Short answer

The US dollar will depreciate and therefore the value of rate of exchange falls. the autumn in expected inflation in Europe ends up in a fall within the charge per unit and which create a decline within the relative expected return on dollar assets. The expected euro appreciates and it'll be greater than the decline within the foreign rate. thanks to the decline within the relative expected return on dollar assets make a leftward shift of the demand curve, and therefore the equilibrium U.S. dollar charge per unit falls.

Step-by-step solution

Concept Introduction 

Deflation is that the overall decrease normally indicator of an economy. Deflation causes decrease within the price of products and services which increases exports and increases the combination demand. Exchange rate is that the rate at which domestic currency is exchanged with foreign currency. rate of exchange provides the relative price of fine in terms of domestic and foreign currency. charge per unit is extremely volatile, and it affects the economy's foreign trade. Exchange rate is calculated as:

$\text{Exchange Rate}\left(e^t\right)=\frac{\text{Foreign pricelevel}\left({\mathrm{P}}_t\right)}{\text{DomesticPricelevel}\left({\mathrm{P}}_{\mathrm{d}}\right)}$

Explanation of solution

In the diagram, X axis shows the number of dollar assets.

Y axis represents expected rate of euro and dollar.

The figure shows how the worth of rate falls because the charge per unit and expected return on dollar assets falls.

Depreciation of currency means the decrease within the value of domestic currency relative to foreign currency. Depreciation of currency makes domestic goods cheaper relative to the foreign goods. Appreciation of currency implies that the rise within the value of domestic currency relative to foreign currency. Appreciation of currency makes foreign goods cheaper relative to the domestic goods.