Question

Using the asset market approach (Uncovered Interest Parity holds), demonstrate the impact on the E($/€) graphically (F/X graph) of a temporary increase in the money supply in the Eurozone. The U.S. is the home country. Label your short run equilibrium point B. How will this affect the U.S. interest rate and Price level in the short run?

Answer 1

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Question:

Answer:

Exchage quote = USD/Euro

According to the question, a temporary increase in the money supply in the Eurozone. Uncovered interest rate parity theory refers that the difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period.According to uncovered interest rate parity, the country with the higher interest rate will experience depreciation in its domestic currency value relative to the foreign currency value with the lower interest rate.

Graphical representattion:

Note: Rise in E denotes home currency dereciation.

Here increasing money supply shift LM curve right from LM to LM2 that depreciate the USD from E1 to E.It will depreciate USD. Deprecaiting currency means high price level.

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