Question

1. Use the money market and foreign exchange (FX) diagrams to answer the following questions. This question considers the relationship between the euro (e) and the U.S. dollar ($). Let the U.S. be “Home” and the European Monetary Union (EMU) be “Foreign”. Let the exchange rate be defined as U.S. dollars per euro, E$/e. Assume, for simplicity, that European money supply, M∗ , liquidity preferences L ∗ , price level P ∗ , nominal and real interest rates, i ∗ and r ∗ , and output, Y ∗ , are fixed in the short and long run; for the U.S., output Y is fixed in the short and long run. All other variables – M, P, i, r, Ee , E – are assumed to be steady and at constant levels in the long run. Furthermore, prices in the U.S. are assumed to be “sticky” (fixed) in the short run. Suppose that with financial innovation in the United States, real money demand in the United States decreases (i.e., LUS(·) ↓ for any given nominal interest rate i). Clearly label your graphs. On all graphs, label the initial equilibrium point A. (a) Assume this change in U.S. real money demand is temporary. Using the FX/money market diagrams, illustrate how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C. (b) Assume this change in U.S. real money demand is permanent. i. Using a new diagram, illustrate how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C. ii. Illustrate how each of the following variables changes over time in response to a permanent reduction in real money demand: • nominal money supply MUS, • price level PUS, • real money supply MUS/PUS, • U.S. interest rate i$ , • and the exchange rate E$/e.

Answer 1

Part A

In the diagram, the long run values are the same because the shock is temporary. Also, we know that the temporary shocks give a reversal of money demand before the price level adjusts. So, MD returns to MD2 to MD1 even before the price changes.

Part B

In the long run, the level of prices increases to adjust the money demand. Because the central bank cannot change the money supply. So, the nominal rate of interest return to initial values. For this, the price level should increase to reduce the money supply. That means the reduction of the money supply will intersect the money demand. The exchange rate would change because the shock is permanent. FX curve also shifts upwards.