Question

If the Fed announces that it will fix the exchange rate at 100 yen per dollar, but with the current money supply the equilibrium exchange rate is 150 yen per dollar, then the money supply must be increased to maintain the Fed's announcement. True False

Answer 1

The statement is True. This is because if the Fed increases the money supply then the interest rate will decline, due to the fact that for a given level of income an increase in the money supply raises the speculative demand for money which cause bond prices to increase and interest rate to decline. Decline in the interest rate will result in capital outflow as investors will move to countries with comparatively higher interest rate. This will raise the demand for foreign currency and foreign investors will convert their holdings of Dollars into Yen. This will put pressure on the exchange rate depreciate from the current 150 Yen per Dollar, and will move towards the target exchange rate of 100 Yen per Dollar.