QUESTIONS AND PROBLEMS (CHAPTER 3)

1. Explain the following figure

The figure shows:

 The Federal Reserve and European Central Bank control the money
supplies (M$US and M€)

 These money supplies flow into the respective U.S. and European money
markets

 The U.S. and European money markets are linked in the foreign exchange
market

 In the foreign exchange market, the dollar/euro exchange rate (E$/€) is

determined based on the dollar interest rate (R$) and euro interest rate
(R€)
2. Using a figure describing both the U.S. money market and
the foreign exchange market, analyze the effects of a
temporary decrease in the European money supply on
the dollar/euro exchange rate.
A temporary decrease in the European money supply would likely lead to an
appreciation of the euro relative to the US dollar, causing the dollar/euro
exchange rate to increase.
scarcity would exert upward pressure on European interest rates.

3. Using a figure describing both the U.S. money market

and the foreign exchange market, analyze the effects of
an temporary increase in the U.S. GNP on the
dollar/euro exchange rate.
An temporary increase in the U.S. Gross National Product (GNP) would likely
lead to an appreciation of the US dollar relative to the euro, causing the
dollar/euro exchange rate to decrease.

Increased demand for dollar, the Federal Reserve (the central bank of the US)
may tighten monetary policy by raising interest rates.

 The increased demand for US dollars would cause the dollar to appreciate
in value relative to other currencies, including the euro.


4. Using figures for both the short run and the long run, show
the effects of a permanent increase in the U.S. money
supply. Try to line up your figures to the short and long run
equilibrium side by side. Assume that the U.S. real national
income is constant.
5. Explain why a permanent change in the money supply has
a greater effect on the short-run exchange rate than a
temporary change.
6. Analyze the effect of a permanent increase in the
European money supply on the short-run dollar-euro
exchange rate.
A permanent increase in the European money supply would likely:

 Lower European interest rates and demand for euros in the short run

 Cause the euro to depreciate against the dollar in the short run, decreasing
the dollar/euro exchange rate

7. In reality, we observe a close but not exactly proportional

relation between money growth and inflation rate.
Explain this.
The reasons why money growth and inflation rate do not have an exactly
proportional relation:

1. Lags in monetary policy transmission

2. Fluctuations in money velocity

3. Changes in output and productivity

4. Unanchored inflation expectations

5. Other supply and demand shocks