Question

Consider the Fed’s current efforts to keep interest rates low by devaluating the dollar. How does this play into inflation, and what impact will this have upon the foreign exchange market?

Answer 1

Devaluation causes inflation to increase, thus the firms find it more attractive to export. Devaluation indicates that imports will become more expensive and thus demand for imports will decline. Inflation will likely to occur because imports become expensive thus causing cost push inflation; aggregate demand is increasing causing demand pull inflation; and when exports becomes cheaper the manufacturers may have less incentive to reduce cost and become more efficient thus costs, over time may increase. To counteract the effects, governments might raise the rates of interest to reduce the internal demand and might sell part of their reserves in foreign currency for stabilizing the exchange rate.