Question

international of finance.

The answer is given. Just want to know the solving  process. Thanks!

5) At time t=0, R$ = 10%, Re = 10%, and Eg € = Egye = 1. Assume that European Central Bank permanently contracts money supply in Europe by 20% at time t=1. In addition, assume the following: 1) The policy change was not anticipated at t=0 2) Prices are fixed in the short run 3) Prices completely adjust to the change in money supply in the long run 4) Output is always fixed at Y 5) Rs = 10% at t=1 Select the most appropriate option: A) E$/e < 1.25; Es/e = 1.25; Re < 10% at t=1 and Egye = 1.25; Este = 1.25; Re = 10% in the long run B) Ep/e > 1.25; Esje > 1.25; Re > 10% at t=l and Eyje = 1.25; Es/e = 1.25; Re = 10% in the long run C) Ege = 1.25; Esſe > 1.25; Re > 10% at t=1 and Egye = 1.25; Esje = 1.25; Re = 10% in the long run D) Ee < 1.25; Esſe > 1.25; Re > 10% at t=1 and Egge = 1.25; Esſe = 1.25; Rę = 10% in the long run E) Esse = 1.25; Es/e > 1.25; Re > 10% at t=1 and Esje = 1.25; Es/e = 1.25; Re > 10% in the long run

Answer 1

In the short run, as the money supply of euro decreases by 20%, that is it becomes 4/5 of the initial money supply and

R$ remains the same at 10%, aggregate supply curve shifts downward and output reduces. This leads to an appreaciattion of euro and depreciation of dollar. From the exchange rate formula, expected prices for euro increase to 5/4 that is 125% or 1.25 and hence expected exchange rate is 1.25. But in the short run, output reduces more than expected and exchange rate is more than expected one. Prices in Euro, i.e R will increase from 10%.

In the long run, as all the factors normalise and actual exchange rate becomes equal to expected which this time is 1.25. Prices would come back to 10% because all the adjustment would be in terms of output.

Hence, option c is correct.