Question

1. Use the money market and FX diagrams to answer the following questions.

This question considers the relationship between the United States ($) and the British Pound (£). The exchange rate is in dollars per pound .

On all graphs, label the initial equilibrium point A and label all your axes correctly.

Illustrate how a temporary increase in the United States' money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.

Illustrate how each of the following variables changes over time (for the United States): nominal money supply, price level, real money supply, United States’ interest rate, and the exchange rate  .

Answer 1

In this IS LM framework, the initial equilibrium point is A, with exchange rate is E0. In short run, the upward sloping LM curve will shift right with temporary rise in the money supply. Thus the exchange rate will fall down. The devaluation of money value increases the overall production in the economy. The value of US dollar falls down with respect to British pound.