If the US economy is operating near full employment and the

If the U.S. economy is operating near full employment and the exchange rate increases (the dollar appreciates), explain why the Federal Reserve will be less inclined to raise interest rates.

Solution

When the economy operates near full employment, the GDP equals the potential output. Inflation is inherent because of the bank’s ability to issue credit to consumers and businesses with very little collateral. This floods the market with money, reducing the value of the dollar. If the exchange rate then increases, it counters the decrease in currency value and the people have disposable income which drives up prices and increase inflation. The exchange rate increase would play the role of an interest rate increase by slowing down inflation. If the increase is not there, Fed would increase interest rates to force bankruptcies, and bring unemployment back to healthy levels.

The most powerful weapon in the Fed’s arsenal is the ability to influence the direction of interest rates. The Federal Reserve is responsible for maintaining full employment while keeping interest low. When interest rate are low capital is easier to acquire and this will spur economic development. The more available cash people have the more likely they are to pay for something they want. If it remains unchecked, it’s “too much money chasing too few goods” which leads to inflation.