Question

Suppose that there are two economies only, local and foreign. Predict the changes in the exchange rate E, defined as local currency per foreign currency, under each of the following situation with interest parity model.

1.Local real output (Y) increases, assuming people do not adjust their expected exchange rate (short-run effect and long-run effect )

2.Local nominal money supply (M) decreases, assuming people do adjust their expected exchange rate (short-run effect and long-run effect )

3.Foreign nominal money supply (M*) increases, assuming people do adjust their expected exchange rate (short-run effect and long-run effect )

Answer 1

1. An increase in Real output will appreciate the local currency, because quantitative theory of money holds true here, which says that: MV=PY

here, M= money supply

V= how often money changes hands

P = price level

Y= GDP or real output

so, if we keep MV constant and increase Y it will lead to increase in the exchange rate and thus domestic currency appreciates, but in short run this appreciation reflects more and in long run both the demand and supply forces tend to balance the changes occured due to the change in GDP(Y).

(2). Here also if we see the above formula again, decrease in 'M' will lead to a further decrease in 'P' which is the general price level in the economy.

If general price level decreases the inflation also decreases. thus it will lead to a similar effect on the exchange rates, this effect will have an impact on the economy more in short run, but in long run pocily change will further balance the change.

(3). if the money supply in foreign will increase it will increase the price of goods in the market which will cause inflation in the foreign country and people will not buy goods as it will cost them more. As only two economies are considered here, so people of foreign country will tend to import goods from the other country and this will appreciate the domestic currency and depreciate the foreign currency.