Final answer:
The value of the U.S. dollar will appreciate if the demand for U.S. dollars increases due to higher rate of returns on U.S. stocks and bonds relative to foreign ones, as indicated by the demand and supply shifts in the foreign exchange market.
Step-by-step explanation:
If the rate of returns on foreign stocks and bonds has increased relative to the rate of returns on U.S. stocks and bonds, then this usually indicates that U.S. assets are becoming less desirable to international investors, leading to a decrease in demand for U.S. dollars on foreign exchange markets. However, your question appears to refer to U.S. assets increasing in desirability, as international investors will demand more U.S. dollars to purchase U.S. government bonds. This is typically the case when U.S. interest rates are higher than those of other countries or the returns on U.S. investments are more attractive for other reasons.
In the scenario described, where demand for U.S. dollars on the foreign exchange market shifts from Do to D₁ and the supply of U.S. dollars falls from So to S₁, the exchange rate would actually appreciate, meaning that the value of the U.S. dollar would increase in relation to other currencies. At the new equilibrium (E₁), if the exchange rate has appreciated to 1.05 euros per dollar, it indicates that the dollar has strengthened relative to the euro.
Therefore, based on the example provided, if the rate of returns on foreign investments relative to U.S. investments is on the rise and the demand for U.S. dollars increases while supply decreases, the value of the U.S. dollar will appreciate relative to other currencies.