Question

If the U.S. economy is operating near full employment and the exchange rate increases (the dollar appreciates), explain why the Federal Reserve will be less inclined to raise interest rates?

Answer 1

When a country operates near a full employment level and the exchange rate increases then there will be a trade deficit as the imports will become relatively cheaper. There will be a negative effect of trade deficit on the aggregate demand as it will fall. The economy will move away from the full employment due to fall in equilibrium price and output caused by the appreciation of the currency. Now if Fed increases the interest rate then it would further lead to increase in savings and decrease in consumption. Equilibrium price and output will fall further due to increase in interest rate and move economy further away from full employment.