Question

Use the exchange return function between the Euro and the US dollar and the domestic money demand and money supply functions to trace the consequences of (a) an increase in the real money supply, and (b) a decrease in the real money supply. Carefully identify all the steps for each case beginning with equilibrium values for current exchange rate of the Euro in dollars, the expected exchange rate of the Euro in dollars one year from today, the current price level, the current interest rate, the current money supply and potential changes in all these variables after the Fed increases of (independently) decreases its real money supply.

Answer 1

a) increase in money supply .

in digram A , initial money supply = Mus , Price = P us , real money supply = Mus/Pus , current interest rate( rate of return in $ terms ) = OR1 and the exchange rate = OE1.

an increase in money supply causes the Mus/Pus curve to shift downwards such that real money supply now becomes Mus'/Pus .At this level , the rate of return in dollar terms to falls from OR1 to OR2 causing the dollar return to fall . A fall in rate of return causes the exchange rate to depreciate from OE1 to OE2 .

b) decrease in real money supply .

in digram b , initial money supply = Mus , Price = P us , real money supply = Mus/Pus , current interest rate( rate of return in $ terms ) = OR3 and the exchange rate = OE3.

an decrease in money supply causes the Mus/Pus curve to shift upwards such that real money supply now becomes Mus'/Pus .At this level , the rate of return in dollar terms increases from OR3 to OR4 causing the dollar return to increase . A increase  in rate of return causes the exchange rate to appreciate from  OE3 to OE4.