Question

Use the money market and FX diagrams to answer the following questions about the relationship between the Home and the foreign currency (E_h/f: home in terms of foreign; per unit (1) foreign currency).

Consider how a change in foreign Money supply affects interest rates and exchange rates.

On all graphs, label the initial equilibrium point A.

a) Illustrate graphically how a temporary decrease in the foreign Money supply affects the money and FX markets in the short run and in the long run.

Briefly explain your graphical results in words emphasizing the underlying mechanism that drives the results

b) Illustrate how a permanent decrease in the foreign Money supply affects the money and FX markets in the short run and in the long run.

Briefly explain your graphical results in words emphasizing the underlying mechanism that drives the results

Answer 1

As per the Problem , The expecter Exchange Rate in terms of Foreign Currency= (Spot Exchange Rate in terms of Foreign Exchange)^2

So The Home Currency is expected to get higher value in Futute, Though we know that real exchange rate = Nominal exchange rate* Rate of price level

The Graph will be like this-

b) if the Money Supply of the home Currecy increases, then demand for the money will decrease, and the interest rate will reduce, the Future Exchange rate in terms of Foreigh Currency will be even more.