Exercise 1 Use the money market and foreign exchange (FX) diagrams to answer the following questions....

Exercise 1 Use the money market and foreign exchange (FX) diagrams to answer the following questions. This question considers the relationship between the euro and the U.S. dollar ($). The exchange rate is in U.S. dollars per euro, E$/e. Suppose that with financial innovation in theUnited States, real money demand in the United States decreases. On all graphs, label the initial equilibrium point A.

(a) Assume this change in U.S. real money demand is temporary. Using the FX and money market diagrams, illustrate and explain how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C. (Due to the temporary nature of the shock, assume that the reversal of real money demand occurs before the price level adjusts in the long run.)

(b) Assume this change in U.S. real money demand is permanent. Using a new diagram, illustrate and explain how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.

(c) Illustrate and explain how each of the following variables changes over time in response to a permanent reduction in real money demand: nominal money supply M_US, price level P_US, real money supply M_US/P_US, U.S. interest rate i_$, and the exchange rate E$/e.

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Expert Solution

Rahul Sunny answered 1 year ago

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