Question

1.Explain how permanent increase in national real money demand functions affects real and nominal exchange rates in the long run.

2.A new government is elected and announces that once it is inaugurated, it will increase money supply.

(a) Use the DD-AA model to study the economy‘s response to this announcement.

(b) What is the further effect on the economy when the monetary expansion is actually implemented as promised?

Answer 1

1) A permanent increase in national real money demand functions will not affect the real money exchange rate in the long run. This is because the real money exchange rate is a monetary factor. In the long run the interest rate also remains unchanged because of the adjusting aggregate price level. Nominal interest rate also remains unchanged since the growth rate remains fixed. R remains unchanged due to decreasing long run price level. Hence nominal exchange rate decreases due to the long run price level and real exchange rate remains unaffected due to permanent increase in real money demand functions.

2) a) When the government announces an increase in money supply immediately after it is elected, there will be interest rate variations which leads to changes in expected future exchange rates. The expected exchange rate will depreciate as this increase in money supply will reduce the interest rates. This policy of the government will have a psuedo effect on the economy

b) When the monetary expansion is implemented, the increase in money supply will lower interest rates, increase demand and hence boost the economic growth.