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Question 1 of 9

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Suppose that the United States Federal Reserve raises interest rates, while the Bank of England leaves Britain’s interest rates unchanged.

All else equal, after the rate change we would expect American assets to be to foreign investors.

Since investors seek the highest rate of return, higher interest rates make an investment more attractive.
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All else equal, after the rate hike we would expect British assets to be to American investors.

Britain’s rates are now relatively lower compared to America’s. U.S. investors have no incentive to invest overseas.
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On the following supply-and-demand graph for British pounds, we would expect poundholders to supply British pounds in the foreign exchange markets (versus the dollar) after the rate increase.

The graph shows the demand and supply curves. The horizontal axis is labeled Q of pounds, and the vertical axis is labeled E, or the exchange rate of dollars to pounds. The supply curve is an upward sloping line labeled S. The demand curve is a downward sloping line that intersects thesupply curve approximately in the center.
Since U.S. assets are now more attractive, British investors will offer more pounds as they invest overseas.
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The graph shows the demand and supply curves. The horizontal axis is labeled Q of pounds, and the vertical axis is labeled E, or the exchange rate of dollars to pounds. The supply curve is an upward sloping line labeled S. The demand curve is a downward sloping line that intersects thesupply curve approximately in the center.

We would expect dollar holders to demand British pounds in the foreign exchange markets after the rate increase.

Since Americans will want to keep their money at home, they will not want to purchase as many pounds.
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The graph shows the demand and supply curves. The horizontal axis is labeled Q of pounds, and the vertical axis is labeled E, or the exchange rate of dollars to pounds. The supply curve is an upward sloping line labeled S. The demand curve is a downward sloping line that intersects thesupply curve approximately in the center.

As a result, demand (D) and supply (S) .

U.S. investors want fewer pounds and British investors want more dollars.
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The graph shows the demand and supply curves. The horizontal axis is labeled Q of pounds, and the vertical axis is labeled E, or the exchange rate of dollars to pounds. The supply curve is an upward sloping line labeled S. The demand curve is a downward sloping line that intersects thesupply curve approximately in the center.

The pound will , while the dollar will .

The supply and demand shifts combine to result in a lower value of the pound. If a currency is desired less, it should depreciate. At the same time, the dollar is more desired, and as a result it appreciates.
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The graph shows the demand and supply curves. The horizontal axis is labeled Q of pounds, and the vertical axis is labeled E, or the exchange rate of dollars to pounds. The supply curve is an upward sloping line labeled S. The demand curve is a downward sloping line that intersects thesupply curve approximately in the center.

This pound depreciation will cause British imports from the U.S. , British exports to the U.S. , and net British exports (X – M) .

A weaker currency makes exports cheaper and imports more expensive. Both these effects combined, (X – M) must therefore increase.
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The graph shows the aggregate supply-aggregate demand curve. The horizontal axis is labeled Aggregate Output, and the vertical axis is labeled Aggregate Price Level. The short-run aggregate supply curve is an upward sloping line labeled SRAS. The aggregate demand curve, labeled AD, is a downward sloping line that intersects the SRAS curve approximately in the center.

On the short-run AS-AD graph for Britain, this change in net exports is represented by a shift in the curve.

Since AD = C + I + G + (X – M), an increase in net exports shifts AD to the right.
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After this shift, the British price level , while British GDP .

The graph shows the aggregate supply-aggregate demand curve. The horizontal axis is labeled Aggregate Output, and the vertical axis is labeled Aggregate Price Level. The short-run aggregate supply curve is an upward sloping line labeled SRAS. The aggregate demand curve, labeled AD, is a downward sloping line that intersects the SRAS curve approximately in the center.
The higher import prices increase aggregate demand, which in turn results in increased GDP and price levels.
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