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In: Economics

Draw side-by-side diagrams of the money market and FX market inthe short run. Show what...

Draw side-by-side diagrams of the money market and FX market in the short run. Show what happens to the home interest rate and the exchange rate when the real GDP of the home country decreases while the nominal money supply is unchanged, all else equal.

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Expert Solution

Ans. A decrease in real GDP will decrease the transaction demand for monwy in the economy. This leads to a decrease in money demand for Md to Md' at given interest rate r. If the money supply does not change from Ms, this will lead to decrease in interest rate from r to r'.

A decrease in interest rate will make capital investment in home country less attractive. So, this will increase net capital outflow from the home country. This will lead to increase in demand for foreign currency, shifting the demand curve from D to D' leading to depreciation of the home currency i.e. increase in exchange rate from e (Home/Foreign) to e' (Home/Foreign).

Rahul Sunny answered 2 years ago
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