Question

Draw a graph (money market and the interest parity graph) that shows both the short run and long run effect of expansionary monetary policy on the exchange rate. label the long run and short run effect on the graphs clearly. explain what is going on in the graphs.

Answer 1

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Nominal Interest Rate (Percent per Year) MS MSi Left ward slope of demand curve due to decrease in demand for Money as number of credit card users ncreases. 4 SSas 2 MD 2 4 6 810 12 Quality of Money (Trillions of Dollars)

In most growing economies the money supply is expanded regularly to keep up with the expansion of GDP. In this dynamic context, expansionary monetary policy can mean an increase in the rate of growth of the money supply, rather than a mere increase in money. However, the money market model is a non-dynamic (or static) model, so we cannot easily incorporate money supply growth rates. Nonetheless, we can project the results from this static model to the dynamic world without much loss of relevance

M:"P L(is. Y,) 1 2 real money

Suppose the money market is originally in equilibrium in the adjoining diagram at point A with real money supply MS'/P$ and interest rate i$' when the money supply increases, ceteris paribus. The ceteris paribus assumption means that we assume all other exogenous variables in the model remain fixed at their original levels. In this exercise it means that real GDP (Y$) and the price level (P$) remain fixed. An increase in the money supply (MS) causes an increase in the real money supply (MS/P$) since P$ remains constant. In the diagram this is shown as a rightward shift from MS'/P$ to MS"/P$ . At the original interest rate, real money supply has risen to level 2 along the horizontal axis while real money demand remains at level 1. This means that money supply

interest rate is higher than the equilibrium rate. Adjustment to the lower interest rate will follow the "interest rate too high" equilibrium story.