Question

5. Show and describe the effects in US asset markets of the European Central Bank (ECB) implementing expansionary monetary policy in response to a recession. What are the effects on simultaneous equilibrium in the money and foreign exchange markets from the US’ perspective? How does the ECB create the change in the European money market? What happens to the rates of return on deposits? What is the ultimate impact on the USD/EUR exchange rate?

6. The policy scenario described in question 5 is a response to short-run fluctuations. Does that result match up with the long-run response of e? Illustrate and describe the ultimate long-run response of the exchange rate to such a policy. Is there a disconnect between the classical long- run concept of the Quantity Theory of Money and the ultimate change? Why or why not?

Answer 1

a)

• Increasing money supply will reduce the deposit interest rate (because now money supply>money demand, refer to panel 2 in above figure)--> increase in investment. Increase in investment will increase income via multiplier effect and it will increase demand. Since the supply of currency has increased it will decrease it's value --> european currency will depreciate (see the figure, by increasing money supply european exchange rate increase from E1 to E2 --> currency depreciate)
• Central bank can increase the money supply by many ways -eg through Open Market Operations, etc
• As we have already seen, interest rate on deposit will decrease in Europe (in short run)
• Since, €/$ is increasing (fig) so $/€ will decrease . That is currency of US will appreciate wrt Europe currency

B) long run

• But just increasing the money supply won't help because if money supply is increased beyond a point where money demand is interest elastic then increasing money supply won't decrease interest rate at all because interest rate is already very low, called as liquidity trap(see the fig below)
• So no increase in investment or income or demand. And at this point increasing money supply will only increase price --> inflation.
• Yes there is disconnect because according to Friedman Quantity theory of money primary determinant of aggregate demand is only money ( M = kPY). According to the theory, change in money supply has direct impact on PY(instead of through transmission mechanism by first impacting interest rate and then P and Y) and also theory didn't believe in liquidity trap.