Question

Contractionary Monetary Policy:

A) Using the exchange rate market model, illustrate and explain how the monetary policy action identified above may affect the exchange rate. Identify the new equilibrium on the diagram as point B.

B) Using the IS-LM model, illustrate and explain how the economy and the unemployment rate may be impacted as a result of the change in the exchange rate in part a. Identify the new equilibrium on the diagram as point B.

Answer 1

(A)

Contractionary monetary policy decreases money supply and increases interest rate. Higher interest rate increases foreign investment in the country, which increases the demand for domestic currency and increases exchange rate, appreciating the domestic currency.

In following graph, exchange rate (P) and quantity of domestic currency (Q) are depicted vertically and horizontally respectively. D0 and S0 are initial demand and supply curve of domestic currency, intersecting at point A with initial exchange rate P0 and quantity of domestic currency Q0. As demand for domestic currency increases, D0 shifts right to D1, intersecting S0 at point B with higher exchange rate P1 and lower quantity of domestic currency Q1.

(B)

Contractionary monetary policy decreases money supply. This shifts the LM curve to left, increasing interest rate and decreasing output. Lower output increases unemployment rate.

In following graph, interest rate (r) and output (Y)are depicted vertically and horizontally respectively. IS0 and LM0 are initial IS and LM curve, intersecting at point A with initial interest rate r0 and output Y0. As money supply decreases, LM0 shifts left to LM1, intersecting IS0 at point B with higher interest rate P1 and lower output Y1.