Question

2. Consider the exchange rate between the US and China (RMB). The US government lifts restrictions on exporting computer tablets causing a large increase in their export. In addition, the Federal Reserve sees banks decreasing their excess reserves; causing the Fed to reduce the money supply dramatically causing a severe US recession. Together these actions cause the dollar to appreciate in value and to increase the amount of dollars in the foreign exchange market. An exchange rate graph is necessary in justifying this statement. This graph must be explained in your answer.

Answer 1

Increase in exports will increase the demand for dollar, shifting the dollar demand curve rightward, which appreciates dollar and increases the quantity of dollar. A simultaneous recession in US decreases demand for imports, lowering the demand for foreign currency, which further appreciates the dollar and increases the quantity of dollar.

In following graph, Exchange rate (P) and quantity of dollars (Q) are measured vertically and horizontally respectively. D0 and S0 are initial demand and supply curves for dollar, intersecting at point A with initial exchange rate P0 and initial quantity of dollars Q0. As demand for dollar rises, D0 shifts rightward to D1, intersecting S0 at point B with higher exchange rate P1 (indicating dollar appreciation) and higher quantity of dollars Q1.