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In this question, assume that the euro zone is the home "country" and the United States is the foreign country, which means that the exchange rate e, which has the dimensions of local currency per unit of foreign currency, is in units of euros per dollar.

a. From September 2007 to December 2008, the FOMC decreased its target for the federal funds rate. With the help of a graph of the foreign exchange market explain the effect this would have on the dollar (assuming other things equal?including interest rates in the "home country," i.e., the euro zone).

b. How would this affect the euro zone and what action would you recommend that the European Central Bank take in response? Explain the economic reasons behind your recommendation.

c. Would this action, or inaction, benefit the U.S. economy? Explain.

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a. The FOMC decreased its target federal funds rate which is now 0-0.25%. In the foreign exchange market this mean that investors will move their funds from the US to Europe, thus increasing the demand for Euros. This will mean the Euro will appreciate against the dollar. Earlier one got e Euro per dollar, and with lower interest rate one will now get more than e Euro per dollar as the Euro appreciates against the dollar.

b. This will have an impact on the trading patterns. A costlier Euro will make it difficult to export goods in the American market as the European goods become costlier there, ...

Solution Summary

The FOMC is discussed.