Final answer:
Higher U.S. interest rates would lead to increased demand for dollars as investors seek higher returns on U.S. financial assets. In contrast, lower interest rates would result in reduced demand and a depreciated dollar exchange rate, which could stimulate aggregate demand but potentially cause inflation and recession if not managed carefully.
Step-by-step explanation:
Out of the options provided, higher U.S. interest rates would definitely lead to an increased demand for dollars. When U.S. interest rates are higher relative to other countries, holding U.S. financial assets becomes more attractive for investors, as they can earn more interest on these assets compared to those in countries with lower interest rates. This would increase the demand for dollars, as investors need dollars to purchase these U.S. assets.
On the other hand, if U.S. interest rates decline compared to the rest of the world, there would likely be a reduced demand for dollars, as foreign assets may appear more attractive. Consequently, there would be increased supply of dollars as investors sell dollars to acquire foreign currency for investment purposes. This scenario would lead to a depreciation in the exchange rate of the dollar relative to other currencies, such as the euro.
In contrast, a lower U.S. dollar exchange rate could stimulate aggregate demand by making U.S. exports cheaper and imports more expensive, which could shift the short-term aggregate supply curve to the left. This could potentially trigger inflation. If this were met with a tight monetary policy from the Federal Reserve to curb inflation, it could also lead to a recession.