Question

INTERNATIONAL ECONOMICS CHAPTER 15

Suppose the US money supply is reduced. Briefly explain how the following variables will change in each of the following phases

Immediately

a.Real money supply

b.Interest rate

c.Exchange rate (dollars per euro)

d.Price level

Answer 1

Answer : When US money supply decrease then,

a) Real money supply remains unchanged. Because when money supply decrease then inflation rate fall. Due to falling inflation rate people can purchase the same quantity of goods and services by existing money supply after reducing money supply. As peoples are able to purchase the same quantity of goods and services as before after reducing money supply, hence the real money supply remains unchanged.

b) Interest rate increase. There exists an inverse relationship between money supply and interest rate. When money supply increase then interest rate decrease. When money supply decrease then interest rate increase. As here money supply decreases, hence interest rate increase.

c) Exchange rate (dollar per euro) increase. When US money supply decrease then inflation rate fall and interest rate increase. At higher interest rate the value of US currency appreciate. Due to appreciation of US currency the exchange rate (dollar per euro) increase.

d) Price level fall. When money supply decrease then interest rate increase. At higher interest rate people save more and spend less. As a result, the aggregate demand decrease. Due to falling aggregate demand the price level fall.