Suppose nominal interest rates in the U.S. rise from 4.6% to 5% and decline in Britain from 6% to 5.5%, while U.S. consumer inflation remains unchanged at 1.9% and British inflation declines from 4% to 3%. In addition suppose, real growth in the U.S. is

forecasted for next year at 4% and in Britain real growth is forecasted at 5%. Finally, suppose producer price inflation in the U.S. is declining from 2% to 1% while in Britain producer price inflation is rising from 2% to 3.2%. Explain what effect each of these factors would have on the long-term trend exchange rate ( per $) and why?

Nominal interest rates should be adjusted for anticipated inflationary purchasing power loss using current consumer inflation rates as a forecast of future consumer inflation. Hence in the U.S. real rates of interest are 0.4% higher while British real rates have risen by 0.5%, an insignificant difference.

Should the higher real growth rate forecast in Britain prove correct, this factor will cause British imports to increase, American exports to increase, transaction demand for U.S. dollars to increase, and the dollar to appreciate. If the forecasts are reliable, speculators may drive the dollar higher now in anticipation of these events.

Falling producer prices in the U.S. and rising producer prices in Britain imply that American exports will expand again, causing dollar appreciation. The reason is that the PPI measures the expected costs that manufacturers of exports will want to recover in long-term supply contracts written today. So buyers around the world will likely get lower, more attractive prices from American exporters than from British exporters and, therefore, will execute more purchase contracts with American companies.

Two of the three factors suggest longer-term appreciation of the dollar.