Scenario 1

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.

1. 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.
2. Based on the scenario, what will happen to the value of the U.S. dollar? Explain. (Make sure you use the costs of foreign and domestic goods in your explanation.)
3. Based on the changing value of the U.S. dollar in part (B), how will U.S. net exports be affected? Explain.

Scenario 2

The Federal Reserve decreases the money supply in the United States causing interest rates to increase.

1. Draw correctly labeled graphs to show how the increased interest rates in the scenario will affect the demand for the U.S. dollar and supply of the EU euro in the foreign exchange market.
2. Based on the scenario, what will happen to the value of the EU euro? Explain. (Make sure you use the concept of foreign financial investment in your explanation.)
3. Based on the changing value of the EU euro in part (B), how would U.S. aggregate demand be affected? Explain.