Question

Use the money market equilibrium and Foreign Exchange (Forex) market equilibrium to answer the following questions.

In the FX market diagram, the exchange rate is in U.S. dollars per British pound, (E$/£ ) and it is on the X-axis. Rates of return are on the Y-Axis.

US Federal Reserve lowers money supply temporarily.

a. What happens to the price level in the short run?

b. Show the short run change in the US money market equilibrium using a diagram.

c. Describe the short-run impact on interest rate and real money supply in the US.

d. What happens to the price level in the long run?

Answer 1

Answer:-- when US Federal Reserve lowers the money supply permamently. -
a)- the short run , the price level will fall because, when the money supply decrease, the bank left with less money and less and therefore bank cannot lend more and hence the interest rate will increase and investment fall and new business will fall and hence there will be deacrease in the price level. so in the short run, the price level will fall.
b)-

c) The short-run impact on interest rate is that the interest rate will increase because when the money supply decrease, the people will hold more money in hand or money demand increases and bank cannot lend to thier cutomers because of low money and hence interest rate will increase . so, the circulation of money also decrease. so in short run, the interest rate will increase.

d) In the long run, the price level will come to the original long run equilbruim price level.