1. Explain how the international trade flows should initially adjust in response to the changes in inflation (holding exchange rates constant). Explain how the international capital flows should adjust in response to the changes in interest rates (holding exchange rates constant).
With the expectation of a decrease in the British inflation rate when compared to the United States, the response of international trade flows will be a decrease in British consumers’ interest in U.S. products. As a result, the U.S. will be able to export less into Britain. At the same time, British products exported to the U.S. will increase. Since the U.S. will be exporting less and importing more from the U.K., the U.S. trade deficit will increase, as prices will rise and U.S. exports will be more expensive for foreign countries. This will place upward pressure on the pound’s value and downward pressure on the U.S. dollar.
However, if British interest rates are expected to decline and U.S. interest rates are expected to increase, then British investors will find the U.S. interest rates more appealing than their own and will move their capital from Britain to the U.S. As a result, international capital flows will flow in the U.S. and out from the U.K. The investors will receive a higher rate of return if their capital is invested in the U.S. The increase in interest rates will place downward pressure on the pound’s value and upward pressure on the U.S. dollar. The increase in interest rates may be enough to counter-act the increase in U.S. inflation causing the international trade flows to remain steady.
2. Using the information provided, will Mesa expect the pound to appreciate or depreciate in the future? Explain.
The equilibrium exchange rate changes over time as supply and demand schedules change. The British pound changes firstly in that the relative inflation rates can