Question

If the European Central Bank decides to pursue a contractionary monetary policy to fight inflation, what will happen to the value of the U.S. dollar?

Short answer

The Contractionary monetary policy of the european government will increase European interest rates and there'll be increase within the future value of the euro. this may lead to decrease of relative expected return on dollar assets. The demand curve will then shift to the left, and therefore the dollar will depreciate. The diagram shows the effect of Contractionary monetary policy on rate.

Step-by-step solution

Concept Introduction

Monetary policy is employed by the financial organisation to regulate the liquidity of cash from economy to bring the economy to stable condition; this is often done through management of rate of interest and also the monetary resource.

Explanation of Solution

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

$Y$ axis expected rate of euro and dollar.

With contractionary monetary policy there'll be fall in value of dollar assets, hence decrease in demand of dollar assets and fall in rate of exchange.