Question

Assuming market-determined exchange rates, use the supply and demand schedules for pounds to analyze the effect on each exchange rate (dollars per pound) between the U.S. $ and the British pound under each of the following circumstances. Make sure to tell what happened to the value of the dollar and the exchange rate (and use graphs).

The United States unilaterally reduces tariffs on British products.

Answer 1

When US reduces tariff on British goods, compared to pre-tariff period, the British goods become cheaper, so demand for British goods increase, raising the demand for Pounds (to pay for higher imports) and lowering the demand for US dollars. So, pound appreciates and dollar depreciates, increasing the quantity of pounds and increasing exchange rate. In following graph, exchange rate (P) and quantity of pounds are measured vertically and horizontally respectively. D0 and S0 are initial demand and supply curves for pounds, intersecting at point A with initial exchange rate P0 and quantity of pounds Q0. As demand for pounds rises, D0 shifts rightward to D1, intersecting S0 at point B with higher exchange rate P1 and higher quantity of pounds Q1.