Question

Using a figure describing both the U.S. money market and the foreign exchange market, analyze the effects of a temporary increase in the European money supply on the dollar/euro exchange rate. (Show Graph)

Answer 1

An increase in money supply shifts money supply curve to right, decreasing interest rate and increasing quantity of money.

In following graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0. When MS0 shifts right to MS1, it intersects MD0 at point B with lower interest rate r1 and higher quantity of money M1.

(b)

Higher money supply shifts LM curve rightward, reducing domestic interest rate. When interest rate falls, net capital outflow increases. As net capital outflow is equal to net exports, higher net capital outflow increases net exports, which decreases exchange rate (depreciating domestic currency).

In following graph, panel A shows IS and LM curves. IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and initial output Y0.

As money supply increases, LM0 shifts right to LM1, intersecting IS0 at point B with lower interest rate r1 and higher output Y1.

In panel B (showing net capital outflow as inverse function of interest rate), lower interest rate from r0 to r1 increases net capital outflow from NCO0 to NC01.

In panel C (showing net exports as inverse function of exchange rate), an increase in net capital outflow from NCO0 to NCO1 increases net exports from NX0 to NX1 and decreases exchange rate from e0 to e1.