Suppose that the Fed perceives inflation on the horizon and decides to pursue a contractionary monetary policy. Explain the effects of this policy on the exchange rate of the dollar. Be specific. What effect will this policy have on U.S. firms that export to foreign countries? Explain. What effect will this policy have on American consumers' purchases of foreign goods? Explain. Explain how this policy will change (1) the U.S. balance of trade, and (2) the rate of foreign investment in U.S. assets.
The Fed perceives inflation on the horizon and decides to pursue a contractionary monetary policy. This will mean the Fed reduces the supply of money, buys treasury bills, and raises interest rates. Higher interest rates will mean that aggregate demand will fall, and people will reduce consumption while increasing savings.
1. Higher interest rates will mean the demand for securities denominated in US dollars, including T-bills, will rise. This will happen because people will think they can get higher returns with higher interest rates. Higher demand for US dollar will increase the price of the US dollar, or that the US dollar will appreciate against other currencies. This appreciation will hurt US ...
U.S. firms that export to foreign countries are highlighted.