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Exchange rate and inflation

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International Economics (TCOs E and I)

Let the exchange rate be defined as the number of dollars per British pound. Assume there is a relatively lower rate of inflation in U.S. relative to that of Britain.

a. Would this event cause the demand for the dollar to increase or decrease relative to the demand for the pound? Why?

b. Has the dollar appreciated or depreciated in value relative to the pound?

c. Does this change in the value of the dollar make imports cheaper or more expensive for Americans? Are American exports cheaper or more expensive for importers of U.S. goods in Great Britain? Illustrate by showing the price of a U.S. cell phone in Britain, before and after the change in the exchange rate.

d. If you had a business exporting goods to Britain, and U.S. inflation fell as discussed above in this example, would you plan to expand production or cut back? Why?

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The solution answers questions which deal with the effect of inflation on exchange rates.

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Let the exchange rate be defined as the number of dollars per British pound. Assume there is a relatively lower rate of inflation in U.S. relative to that of Britain.

a. Would this event cause the demand for the dollar to increase or decrease relative to the demand for the pound? Why?

Initially, this event would cause the demand for dollar to increase. Lower inflation means that the currency has a higher purchasing power with respect to a currency that has a higher inflation and would be more attractive as assets denominated in this currency would be in higher demand. Americans would buy more goods with dollars and ...

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