Question

(A) Consider the model of long run exchange rate determination. It assumed prices were flexible and income is fixed. There are two countries, the US and Europe. There is no expectation of price stability.

Determine the effects of the following events on the US exchange rate (E$/€ )with Europe.

• a. Europe increases its money supply by twenty percent.

• b. There is economic growth of 4 percent in the US. At the same

  time, the US increases the money supply by 8 percent.

Answer 1

Answer:A

The Increase of Money supply By the europe will cause inflation in the economy and prices of goods will go higher not reflecting their true Value .It will make cheaper US Goods and Europian starts import from U.S increasing Euro supply and Higher dollar demand for payment of import . A per Purchasing Power Parity Theory A permanent increase in a country's money supply causes a proportional long run depreciation of its currency.

Hence the effect of Europe money supply increase by twenty percent will be the depreciation of euro and appreciation of the dollar in the long run and dollar gets stronger means Exchange rate will increase .

Answer: B

Increasing the money supply faster than the growth in real output will cause inflation Because for same number of goods to buy country has more money and it will put up pressure on the firm to raise prices of goods till the equiblirium level of demand supply of goods and services is achieved  .

In the given situation the money supply is 8% and the economic growth of U.S i.e 4% hence Money supply is 4 % extra faster than economic growth will cause inflation in U.S.

In this Event the Dollar as showing inflating value will fall and get weaker compared to euro and exchange rate will adjust accordingly .

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