Suppose it is widely expected that the U.S. economy will grow faster than the Japanese economy, have higher inflation, have a greater growth in money supply, and have low and declining interest rates. Given these expectations, what do the various approaches to exchange rate predict about the value of the dollar?

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: According to the monetary approach to exchange rates, the dollar will lose value against other currencies when money supply growth at home is higher than that abroad. However, when the U.S. economy grows faster than the Japanese economy, money demand in the U.S. will rise, appreciating the dollar. More rapid inflation means prices increase faster at home than abroad. According to relative purchasing power parity, the dollar will depreciate. According to the asset market approach, the low and declining interest rates at home will create portfolio repositioning effects and cause the dollar to depreciate because of increased demand for foreign assets, which offer higher yields due to higher interest rates abroad. Lower interest rates at home mean capital will flow out of the domestic U.S., increasing the supply of dollars in the foreign exchange market, thus the dollar will depreciate.