Assuming sticky prices and given expectations of future exchange rates, what is the short-run effect on the exchange rate of the U.S. dollar (purchasing euros) and on domestic and foreign rates of return if there is a temporary increase in the quantity of euros?
a. Rates of return on domestic and foreign assets diverge, as the dollar appreciates.
b. Domestic and foreign rates of return both fall, as the dollar depreciates.
c. Domestic and foreign rates of return converge, as depreciation of the euro raises r turns for U.S. investors who purchase euro-based assets.
d. Rates of return on dollar assets fall, causing investors to switch into euro assets and, therefore, the U.S. dollar depreciates against the euro
Answer: c. Domestic and foreign rates of return converge, as depreciation of the euro raises r turns for U.S. investors who purchase euro-based assets.
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