Question

Assume that in the long run E$/€ = PUS/PE and that domestic price levels depend on domestic money demands and supplies: PUS = MUSS/L(R$, YUS) PE = ME S /L(R€, YE)

a. What would be the effect on the dollar/euro exchange rate E$/€ of a decrease in the US money supply (holding all other factors constant)?

b. What would be the effect on the dollar/euro exchange rate E$/€ of a decrease in Europe’s output level (holding all other factors constant)?

Answer 1

Exchange rate is given as :

$/€ = P_US/P_E

_{Price level in eacg country is given as :}

P_US = Money Supply_US/Money demand_US

P_E = Money Supply_Europe/ Money demand_Europe

  

Scenario - (a)

As there is a decrease in the money supply in US, the Price in US would decrease according to the given relation between the price level and money supply which is positive.

As the price in US decrease the ratio of price level in both the countries (P_US/P_E) would also decrease which would further lead to the decreass in the exchange rate.

Therefore the exchange rate $/€ would also decrease.

Scenario -(b)

Ans (b) As the output in Europe , the demand for money (L) in Europe would also decrease as it is positively related leading to the income/output .This would lead to the decrease in the ratio (M_E/L).

As the price level in Europe is negatively related to the Money demand, the Price in Europe (P_E) would decrease with the increase in money demand.

The decline in P_E would lead to the increase in the price ratio (P_US / P_E) . As the price ratio increases , the exchange rate also increases.

Therefore $/€ increases.