Question

Suppose that the FED decreases the required reserve ratio. How will this affect the exchange market for U.S. dollars? Explain/show the effect(s) of this move by the FED. Include the initial effect(s), the market adjustment(s), and the final result(s) on equilibrium. (9 pts.)

Answer 1

Ans. Decrease in required reserve ratio by Fed frees up funds with the banks which they can loan out, so, money supply increases. This at given demand for money decreases the interest rate in the market. This decrease in interest rate makes investment in USA less attractive because of the decrease in rate of return. This decreases the demand for US dollars in the market shifting the demand curve leftwards from D to D' which at given supply for US dollars leads to decrease in exchange rate from e to e' and decrease in equilibrium quantity of US dollars from L to L'.

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