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Answer the question by drawing the appropriate exchange market diagram. If expected inflation drops in Europe...

Answer the question by drawing the appropriate exchange market diagram. If expected inflation drops in Europe so that interest rates fall there, predict what will happen to the exchange rate for the U.S. dollar.

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Answer #1

If interest rate falls in Europe, relative interest rate is higher in US, which will make US a more attractive investment destination for global investors. When foreign investment increases in US, demand for US dollar increases, which shifts the demand curve for dollars rightward, increasing exchange rate (and quantity of dollars). The US dollar appreciates.

In following graph, exchange rate (P) and quantity of dollars (Q) are depicted vertically and horizontally respectively. D0 and S0 are initial demand and supply curves for US dollars, intersecting at point A with initial exchange rate P0 and quantity of dollars Q0. When demand for dollars rises, D0 shifts right to D1, intersecting S0 at point B with higher exchange rate P1 and higher quantity of dollars Q1.

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