Suppose there is a permanent decrease in the U.S. money supply. Trace the short-run and longrun effects on the current and expected exchange rate, interest rate, and price level. Draw the twosided diagram to help explain your answer. Also draw the time paths of each of these variables. (We assume the economy starts with all variables at their long-run levels and that output remains constant as the economy adjusts to the changes in money supply, i.e. real output Y is given.) Include in your answer a brief description of how exchange rate overshooting or undershooting may appear in this case. Suppose the Federal Reserve wants to fix the U.S. exchange rate with the yen at $0.008 per yen. If the equilibrium market exchange rate were significantly lower at $0.007 per yen, what would the Fed need to do to maintain the fixed rate of $0.008 per yen? What would be the effect of these actions on the money supply in the U.S.? Explain. Upon reading in the newspaper that the dollar exchange rate with the euro has depreciated 12% in the last month, after a 15% appreciation in the previous month, one of your friends tells you, “I don’t understand a thing about these currency fluctuations. Surely the market must be irrational. Nothing justifies such large movements up and down.” What is your response?

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Exploring Economics

8th Edition

ISBN:9781544336329

Author:Robert L. Sexton

Publisher:Robert L. Sexton

Chapter26: Monetary Policy

Section: Chapter Questions

Problem 3P

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Suppose there is a permanent decrease in the U.S. money supply. Trace the short-run and longrun effects on the current and expected exchange rate, interest rate, and price level. Draw the twosided diagram to help explain your answer. Also draw the time paths of each of these variables. (We assume the economy starts with all variables at their long-run levels and that output remains constant as the economy adjusts to the changes in money supply, i.e. real output Y is given.) Include in your answer a brief description of how exchange rate overshooting or undershooting may appear in this case.

Suppose the Federal Reserve wants to fix the U.S. exchange rate with the yen at $0.008 per yen. If the equilibrium market exchange rate were significantly lower at $0.007 per yen, what would the Fed need to do to maintain the fixed rate of $0.008 per yen? What would be the effect of these actions on the money supply in the U.S.? Explain.

Upon reading in the newspaper that the dollar exchange rate with the euro has depreciated 12% in the last month, after a 15% appreciation in the previous month, one of your friends tells you, “I don’t understand a thing about these currency fluctuations. Surely the market must be irrational. Nothing justifies such large movements up and down.” What is your response?

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