Consider the short-run money market model and the short-run exchange rate model together: a. Draw the combined models in a single graph, showing the initial domestic interest rate (r1) and the initial exchange rate (e1) b. Show how the short-run model would change with a decrease in domestic money supply, specifically noting the impact on domestic interest rates, exchange rates, and the price level c. Following on from part (b), explain why the exchange rate changes d. In the long-run, what will be the impact on domestic interest rates, exchange rates, and the price level?
b) A fall in domestic money supply leads to upward shift in the LM curve from LM to LM' which increases the interest rate from r1 to r2 causes a increase in domestic return on assets which decreases the exchange rate from e1 to e2 causes a appreciation of domestic currency, as in the short run, price level are fixed so real interest rate increases more to balance the decrease in money supply.
c) Decrease in money supply increases the interest rate in the domestic country which causes a higher interest rate in domestic country than the world leads to inflow of currency in the domestic country which increases the demand for domestic currency in the foreign exchange market causes a appreciation of domestic currency which leads to fall in exchange rate which shows value of foreign currency in terms of domestic currency.
d) In the long run, when price level becomes flexible and begins to fall toward its long run level which makes real money supply backs to its previous level and shifts the LM curve downward back to its original level from LM' to LM which shifts the real interest rate downward from r2 to r1 and similarly exchange rate increases from e2 to e1 in the economy.
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