Explain how the following factors affect the value of the dollar vis-à-vis other currencies under a floating exchange-rate system.a. Tariffs and quotas are placed by the U.S. government on all imports into the country.b. Demand by foreign consumers for the U.S. exports falls and the U.S. demand for imports rises.c. Rising interest rates in the United States relative to interest rates in Europed. Rising U.S. fiscal deficits reduce investor confidence and lead to capital outflows.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE:

a. Tariffs and quotas placed by the U.S. on all imports into the country would decrease U.S. imports and thus decrease the demand for foreign currency. This, in turn, would lead to an appreciation of the dollar vis-à-vis other currencies.

b. By itself, decreased demand by foreign consumers for U.S. exports would decrease demand for U.S. dollars and lead to a depreciation of the dollar vis-à-vis other currencies. By itself, an increased U.S. demand for imports would increase demand for foreign currency, so, the foreign currency would appreciate and the dollar would depreciate. The two changes together therefore would depreciate the dollar.

c. Rising interest rates in the United States relative to interest rates in Europe leads to capital inflows. To invest in the United States, foreign investors would first have to purchase dollars in the foreign exchange market. This would increase the demand for dollars, thus appreciating the dollar vis-à-vis other currencies.

d. The capital outflows affect the foreign exchange market. Investors would have to sell dollars to buy foreign currency; thus, the supply of dollars would increase and the demand for foreign currencies would increase. The dollar, as a result, would depreciate vis-à-vis other currencies.