Question

1)

a) Use the IS/LM model and the FOREX market to illustrate how a decrease in the U.S. money supply affects its own output and its exchange rate with the EU in the short run.

b) discuss how expected exchange rates change to illustrate the long run effects of a permanent money supply reduction on the exchange rates.

Answer 1

*Answer:

If exchange rate decreases, then we’ll be able to buy more foreign currency with less of our own currency.

On the other hand, foreigners we’ll need to pay more of their currency to buy our own.

Therefore, when exchange rates decreases, also called an appreciation under flexible exchange rates or a revaluation under fixed exchange rates, domestic residents have more purchasing power.

Thus, being able to buy the same amount of goods using less domestic currency. The opposite works in the same way: if exchange rates increases (also called a depreciation under flexible exchange rates or a devaluation under fixed exchange rates), domestic residents will pay more for the same goods.

To sum up, an increase in e causes net exports to increase (IS curve shifts to the right) and a decrease in e causes net export to decrease (IS curve shifts to the left).

The interest rate is an increasing function of the output level.

When output increases, the demand for money raises, but, as we have said, the money supply is given.

Therefore, the interest rate should rise until the opposite effects acting on the demand for money are cancelled, people will demand more money because of higher income and less due to rising interest rates.

The interest rate is an increasing function of the output level. When output increases, the demand for money raises, but, as we have said, the money supply is given.

Therefore, the interest rate should rise until the opposite effects acting on the demand for money are cancelled, people will demand more money because of higher income and less due to rising interest rates.

The slope of the curve is positive, contrary to what happened in the IS curve. This is because the slope reflects the positive relationship between output and interest rates.

Exchange Rates in the Long Run, A permanent increase in a country's money supply causes a proportional long run depreciation of its currency.

An increase in the euro zone’s money supply causes a depreciation of the euro (an appreciation of the dollar).

A decrease in the euro zone’s money supply causes an appreciation of the euro (a depreciation of the dollar)

A permanent decrease in a country’s money supply causes a proportional long run appreciation of its currency.

However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation.

***Please please like this answer so that I can get a small benefit. Please support me. Thankyou***