Question

Use the foreign exchange and money market diagrams to answer the following questions about the relationship between the Indian rupee (INR) and the Euro (EUR). Let the exchange rate be defined as rupees per yuan EINR/Eur. Suppose there is a fall in the Indian nominal money supply. Make the usual assumptions: UIP holds, PPP holds in the long run, prices are sticky in the short run, (20p)

. Assume first that the fall in money supply is temporary (so that the nominal money supply is put back at its original level in the long run). Illustrate the effects of this in a pair of graphs, one for the Indian money market and one for the foreign exchange market. Label the initial equilibrium as point A, the short-run equilibrium point B, and your long-run equilibrium point C .

Answer 1

an INR money supply falls , with sticky prices, real moeny supply falls from Ms to Ms' , given the money demand level of Md, return on indian bonds(in terms of INR)  will increase from r to r' (on horizontal axis) from point A to B. this is in short run.

in foreign exchange market, taking that UIP holds, an increase in returns in INR will attract investors to flow their capital into India, demand for INR will increase and that for euros will decrease. given the amount of domestic demand and foreign demand for INR, INR will appreciate. echange rate e will decrease from level e to e' in upper part of the graph, from A to B

this holds in short run when prices are sticky.

in long run when prices adjust to the level of moeny supply, then (real moeny supply) level of moeny supply is Ms, new equilbirum C will be at Point A with interest rate back to its intial level of r, and thus, e' will increase back to e level, causing INR to depriciate to initial level.

with e = inr/euros and euro being the foreign currency,