Question

1. For some reason there is a permanent increase in money supply in the Country A domestic money market. Consider the effects this might have on the value of the Country A dollar relative to the U.S dollar in the foreign exchange market. Prices are fixed in the short-term, the output is exogenous, uncovered interest rate parity holds, and there is no change in the conditions of the U.S money market. Country A has floating FX rate policy and this is an Exchange rate overshooting case.

A. Show graphs of what happens in the Country A domestic money market and foreign exchange market in the short term. (Label all curves and show with arrows in the graph how curves shift). State what direction the following Country A variables move in the short-term: the nominal exchange rate (Country A dollar per U.S. dollar), the nominal Country A interest rate, and the real exchange rate (Country A goods per U.S. good).

B. Now analyze the long-term effects. Again show a graph as above, and state what happens to the following variables: nominal exchange rate, nominal interest rate, real exchange rate. (Note: state whether variables are higher or lower than before the change in monetary policy, and be as specific as possible about the magnitudes).

Answer 1

The Exchange Rate in the Short Run

A permanent increase in the money supply only causes a long-run depreciation of the currency (and money is neutral). It causes a large depreciation of the currency and a rise in output in the short run. Thus, the currency appreciates during the adjustment period.

A: The Exchange Rate in the Short Run

An increase in foreign money supply reduces foreign interest rates i. A reduction in foreign interest rates causes an appreciation of the USD on the foreign exchange market (a fall in S).

In the short run price remains fixed.

Effect on the Money Market:

-The increase in the stock of money reduces the home interest rate.

-It also raises output, which increases money demand. The effect, however, is small.

-So, overall, the increase in M reduces i.

Effect on the Foreign Exchange Market:

-The lower interest rate makes foreign investment more attractive. The result is that the foreign currency appreciates.

-In addition, the rise in the long-run exchange rate generates an increase in the expectations of the future exchange rate. This further appreciates the foreign currency.

-This is a shift of the AA schedule to the right.

Effect on the Goods Market:

-The appreciation of the foreign currency raises the real exchange rate. This generates an improvement in the current account and pushes output up.

-This is a slide along the DD schedule.

(Please refer to the diagram below)

B: In the Long Run when there is a perfect Price Flexibility

Effect on the Money Market:

-The rise in M only raises P. Money is neutral in the long run.

Effect on the Foreign Exchange Market:

-The rise in P engineers a long-run depreciation of the home currency (an increase in S).

-This is a shift of the AA schedule to the right.

Effect on the Goods Market:

-The rise in S offset any effects of the rise in P on the real exchange rate and the current account.

-However, at the initial exchange rate, the higher P means a reduction of the real exchange rate and a reduction in output. This shifts the DD schedule to the left.

-Thus, there are both movements of the DD schedule and movements along the DD schedule.

(Please refer to the diagram below)

Now Let us see the adjustment process from the short run to the long run:

In the Money Market:

As prices rise, the interest rate and output are slowly restored to the initial level.

In the Foreign Exchange Market:

The rising home interest rate generates a depreciation of the foreign currency.

In the Goods Market:

Real output is constant in the very short run, and at constant at its full employment level in the long run.

Diagram for Reference:

Image 1:Image 2: