Question: The Fed and the Current Account

Suppose the U.S. current account continues to worsen and the Federal Reserve decides to increase the money supply temporarily in an attempt to affect the deficit. On the left-hand-side graph show what this would do to equilibrium in the money and foreign exchange markets. Explain the likely effect on the current account. Now suppose that the European Central Bank (ECB) decides it does not like this move by the Fed and makes a counter move to neutralize the Fed’s move. What is their likely response? Copy your results from the first graph to the right-hand-side graph and then add the ECB response that would exactly undo the Fed’s actions. Explain the intuition for your result.

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