Question

Suppose the markets change their expectations of the future value of the dollar, such that they expect it to be stronger at that time in the future than their expectation was previously (i.e., Ee decreases). How would this change in expectations affect spot exchange rates assuming interest rates stay constant? What would the central bank have to do to keep the spot rate from changing in the manner you described in part (a)?

Answer 1

If the future value of the dollar is expected to be stronger than previously expected, investors will respond by buying more dollars today.

This is because they will be able to sell those dollars in the future, when it becomes stronger, and thus get more value out of the sale.

Due to this increased demand for dollars today, the spot rate of the dollar will appreciate. In other words, the dollar will become stronger.

If the central bank wants to prevent this from happening, it can increase the domestic money supply. This will lead to a fall in interest rates, and a rise in inflation. This will decrease the demand for dollars. The central bank can also buy forex reserves in exchange for dollars, to increase the supply of dollars in the market.