Question

Consider the foreign exchange market for British pounds from the US perspective (i.e., imagine the supply-demand diagram where the pound is the foreign currency). Draw a diagram to illustrate the impact of the US Federal Reserve using a contractionary monetary policy and state what happens to the value of the British pound.

Answer 1

Solution:

In contraction monetary supply, the central bank decreases the money supply in the country. This can be done using various monetary policy tools such as Sell securities in the open market (Open market operations), raising federal discount rate or raise reserve requirements.

The decrease in the supply, increase interest rates, the demand for domestic currency increases, demand for foreign currency reduces, the exchange rates in terms of domestic currency will reduce.

Please see the diagram below.

The new equilibrium exchange rate (ER2) of US$ per pound is below the old equilibrium exchange rate (ER1).

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