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Consider the model of long run exchange rate determination. It assumed prices were flexible and income...

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.

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Answer #1

A - If the europe increases its money supply , the demand in the economy will rise. This will lead to greater demand for imports. Hence demand for US $ will increase. Hence Euro will depreciate against the US dollar . Hence For Europe , Exchange rate will rise.

B - If the rise in money supply is greater than GDP growth , this signifies inflation. Value of the currency will drop down. Hence US dollar will depreciate and Euro will appreciate. For US , the exchange rate will rise .

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