Question

4) Using 4 different figures, plot the time paths showing the effects of a permanent in- crease in the United States money supply on: (a) U.S. Money supply (b) The dollar interest rate (c) The U.S. price level (d) The dollar/euro exchange rate

Answer 1

A rise in the nominal MS increases the real MS, decreasing the interest rates 12 in figure \(\mathrm{B}\). The expected return on the euro is more and the dollar will depreciate. Due to a permanent rise in the MS, the dollar depreciates more than under a temporary rise in the MS(from E1 to E2 and moving back till E3 in figure d). In Iong run, prices will rise(from \(\mathrm{p} 1\) to \(\mathrm{p} 2\) in figure c) until the real money balances are the same as before the permanent increase in the money supply. Since the output level is given, the U.S. interest rate will start to increase, until it will move back to its original level(i1 on figure b). This increase in the interest rate must cause the dollar to appreciate. Eventually, the dollar depreciates in proportion to the increase in the price level, which in turn increases by the same proportion as the permanent increase in the MS. Thus, money is neutral: it cannot affect the long run real variables.