Two questions about exchange rates:

a) Using a supply and demand model with ‘quantity of euros’ on the x axis and ‘price of 1 euro’ on the y axis, sketch a diagram to illustrate what would happen to the exchange rate between dollars and euros if the European Central Bank raised interest rates (assuming that no other central bank changed interest rates). Explain your answer.

b) Say that another country that trades a lot with the U.S. has an exchange rate that is pegged to the U.S. dollar. If the U.S. enters a recession, what would happen to exchange rates and trade without the peg? What would the other country’s central bank have to do to maintain the exchange rate at the pegged level?

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