Expected future exchange rate

EIFM Seminar 6 – week commencing Nov 15th 2021

Question 1: If the Indian government unexpectedly announces that it will be imposing higher tariffs on foreign goods one year from now, what will happen to the value of the Indian rupee today?


The Indian rupee will appreciate. The announcement of tariffs will raise the expected future exchange rate for the rupee and so increase the expected appreciation of the rupee. This means that the demand for rupee denominated assets will increase, shifting the demand curve to the right, and the rupee exchange rate therefore rises. (Replace $ with Rupee in the graph below)


Question 2: In September 2012, the Federal Reserve announced a large-scale asset-purchase program (known as QE3) designed to lower intermediate and longer-term interest rates. What effect should this have had on the dollar/ euro exchange rate?

Answer: The quantitative easing program should reduce the demand for U.S. dollar-denominated assets, and lead to an appreciation of the euro (a depreciation of the dollar). In fact, immediately after the policy announcement on September 13, 2012, the dollar depreciated almost 2% against the euro. (Swap $ with € in the graph below)

Question 3: If a strike takes place in France, making it harder to buy French goods, what will happen to the value of the U.S. dollar?

Answer: The strike will make it harder to get French goods, so the French will buy more foreign goods and the rest of the world will buy less French goods and the value of the euro in the future will fall. The expected depreciation of the euro lowers the expected return on euro assets at any exchange rate, so the demand for euros declines and the demand for dollars shifts to the right, as shown in the graph below. Thus, the dollar will appreciate.

Question 4: When the Federal Reserve conducts an expansionary monetary policy, what happens to the money supply? How does this affect the supply of dollar assets? How does this affect the dollar exchange rate in the short run and long run?

Answer: The money supply increases, but this has an insignificant effect on the supply of dollar assets. Since dollar currency is a small part of total U.S. dollar denominated assets, changes in the money supply are relatively small and therefore do not shift the supply curve. However, the expansionary monetary policy will increase inflation expectations and lower interest rate, both of which will lower the relative expected return of dollar assets, shifting the demand curve to the left, from D1 to D2. The dollar will depreciate. In the long run, the domestic interest rate returns to its previous value, and the demand curve shifts back to the right somewhat, from D2 to D3. The exchange rate rises to some extent, but still remains below its initial level due to the permanently higher relative price level.