Question

Suppose foreign banks start to keep more reserves in their portfolios, what happens to nominal and real exchange rates of the domestic country (against foreign countries) in the long run? Explain.

Answer 1

hong, hun impocks on Domestic countoies against postign countries. In the long run, money prices of factoss of production and of Goods and a services are allowed to adjust to demand and supply in their respectives markets. Nominal images adjust to the demand and supply for labous. The interest rate depends on the supply of saving a the and demand for saving in the economy and the expected inflation rate - and this is also dependent of the money supply's level. They will offect exchange-seate expectations, Scanned with CamScanner

Dollar/euro exchange rate, Egle Dollar return Money, Prices and the Exchange Rates and Expectations (cont.) E - - - - - - - - - - - Expected euro return Eset--+- " Change in expected return on euro deposits Rates of return (in dollar terms) R2R LORS, YUS) Pus Mus pis The expected return on euro deposits rises because of altered exchange-rate expectations: •The dollar is expected to be less valuable in the future when buying goods and services and also less valuable when buying euros. •The dollar is expected to depreciate in the long run, and this raises the expected dollar return on euro deposits. U.S. real money holdings (a) Short-run effects Figure 14-12 Short-Run and Long-Run Effects of an increase in the U.S. Money Supply (Given Real Output (a) Short run adjustment of the asset markets. (b) How the interest rate, price level, and exchange rate move over time as the economy approaches its long-run equilibrium