Q. Describe the chain of events leading to exchange rate determination for the following cases:
1. An increase in the U.S money supply
2. An increase in the growth rate of the U.S money supply
3. An increase in world relative demand for U.S products
4. An increase in relative U.S output supply
Answer: The chain of events most important to exchange rate determination:
The spot exchange rate is equivalent to the real exchange rate times the ratio of U.S. to European price levels.
Enhance in U.S money supply that the price level in the U.S rises in proportion to the money supply the real exchange rate remains the same. All dollar prices will increase including the dollar price of the euro.
Increase in growth rate of U.S money supply that dollar interest rate, the inflation rate, price level in the U.S and spot exchange rate increase in proportion to the enhance in the price level in the U.S
Increase in world relative demand for U.S products: E decrease and q does as well.
Raise in relative U.S output supply: The dollar depreciates and lowering the relative price of U.S output. The real exchange rate increase the effect on E isn't clear since the real exchange rate and the price level in the U.S work in opposite directions.