Question

The United States' economy is growing at a faster rate than the economy of its trading partner, the United Kingdom. As a result, the rate of American inflation is increasing.Draw correctly labeled graphs to show how the increase in inflation will affect the supply of the U.S. dollar and demand for the British pound in the foreign exchange market.Based on the scenario, what will happen to the value of the U.S. dollar

Answer 1

If the U.S. economy fast paced growth causes inflation to rise, this will make the value of the U.S. dollar go down, because more U.S. dollars will be needed to buy the same amount of goods and services (including foreign currency) since what inflation causes is a loss of purchasing power of the currency.

For this reason, international investors will demand less U.S. dollars in the foreign exchange market, including British investors.

While the supply of U.S. dollars will continue to grow (because inflation is primarily caused by a rise in the money supply) demand will continue to fall, both against the British pound, and other currency. This will further lower the value of the U.S. dollar in the foreign exchange market, while appreciating the British Pound at the same time.