Assignment

Use the money market equilibrium and Foreign Exchange (Forex) market equilibrium to answer the following questions.

In the FX market diagram, the exchange rate is in U.S. dollars per British pound, (E$/£ ) and it is on the X-axis. Rates of return are on the Y-Axis.

a. The US Federal Reserve lowers the money supply permanently.

i. What happens to the price level in the short run?

ii. Show the short run change in the US money market equilibrium using a diagram.

iii. Describe the short-run impact on interest rate and real money supply in the US.

iv. What happens to the price level in the long run?

v. Show the long run change in the US money market equilibrium using a diagram.

vi. Describe the long-run impact on interest rate and real money supply in the US.

vii. What happens to the expected exchange rate?

viii. Show the short run change in Forex market equilibrium diagram.

ix. Describe the short-run impact on the spot exchange rate.

x. Show the long run change in Forex market equilibrium diagram.

xi. Describe the long-run impact on the spot exchange rate.

Answer (i) - (viii) above in each of the following cases.

b. US Federal Reserve lowers money supply temporarily.

c. There is a permanent drop in US real money demand.

d. US Federal Reserve announces its plans to permanently decrease its money supply but doesn't actually implement this policy.

e. Bank of England permanently decreases its money supply but this change is not anticipated by market players.