Question

Use the short-run asset approach to predict the effect of a temporary increase in money supply in the U.S. on expected future exchange rate of dollar against euro and spot exchange rate of dollar against euro.  

Answer 1

In short run asset approach, the nominal interest rate and the expected future exchange rate are exogenously determined. The equilibrium in the foreign market is the condition where the domestic returns equal the foreign returns. Every economy tried to make their equality in the foreign market. But most of the times this equality cannot be obtained.
If US increased the money supply, the domestic interest rate will fall down. The value of dollar interest rate falls down. This will leads to decrease in domestic returns. At this point the value of euro is greater than dollar. This will leads to the depreciation of US dollar. Thus the domestic returns fall down. On the other hand, if there is a fall in the euro rate will leads to the lowering level of foreign expected dollar returns. Thus the total level of foreign returns becomes lesser than the domestic returns. Thus the dollar deposits become more attractive and the value of dollar increases, appreciate. Through increasing the money supply, the spot exchange rate will rise. This rise in the spot exchange rate will increase the foreign returns on euro.