Question 1

Permanent Increase in Aggregate Real Money Demand, for any given level of nominal
interest rate and output level.

a) Trace the short-run and long-run effects of the exchange rate, interest rate and price
level.
Does the nominal interest rate overshoot or undershoot in the short run? What is the
mechanism behind the latter effect?

In the short run, real money demand increase would create increased demand for the local/
domestic currency, which would appreciate the exchange rate.

Interest rate:

In the short run, an increase in aggregate real money demand would result in a shortage of money
supply. As a result, some individuals would prefer getting rid of their interest-bearing assets to
increase their liquidity as they want more to hold more money. They would even want to borrow

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money from others who have it in excess. More people would like to borrow money to increase
liquidity than those who want to lend money to decrease their liquidity. Those who would be
unable to borrow extra money load would try to tempt the lenders by offering them higher interest
rates, causing an upward pressure on the interest rates in the short run.

Money Supply:
In the short run, the money supply will increase as well. The main reason, as shown in the graph,
is that the L(R,Y) curve will shift forward, which will create a new equilibrium point with a higher
real money supply.

Exchange Rate:

In the short term, an increase in aggregate real money demand would increase the demand for the
domestic currency comparable to its supply. Additionally, with the higher interest rate now being
offered, foreign investors would want to shift capital to domestic banks to gain better interest rates.
As a result, the increased demand would put upward pressure on the exchange rate, resulting in its
appreciation. Here, the expected exchange rate is kept constant. It must be noted that there has not
been a shift increase in money supply. Instead, the aggregate real money demand has increased
causing this pattern.

Price Level:

We assume that short-term is the period where money price level is fixed as the prices have not
adjusted to the changes.

Long-Run:

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In the long-run, money prices of factors of production have already adjusted to the changes in
demand and supply. The money supply would give increase to adjust with the increasing money
demand.

There is excess demand, which means that wages will rise, output will increase, and producers will
produce more. As a result, expectations will be caused about inflations which will cause demand
pull inflation. As a result, the principle of long-run neutrality. A proportional increase in price
level will occur. As a result, the exchange rate expectations will change as well. In the long term,
the domestic price level increase will decrease the real money supply and domestic interest rates
will return to their initial level or fall at least. The same can be expected with the exchange rate.
The exchange rate will depreciate to return to closer to the original level.

Long-term will see an increase in domestic price level and it will reduce competitiveness of
domestic products, causing exchange rates to come back to equilibrium. If the increase in money
supply is greater than real money demand increase, interest rate may fall or not change. If the
opposite is true, then domestic interest rates will rise in the long-term.

Overshooting

In the short-term, there will be overshooting of the exchange rate because here, the impact has
been immediate on the interest rates, but not on the expected price level. It also shows why
exchange rate is extremely volatile. Here, the immediate response to the exchange rate is high,
while the exchange rate’s long-term response is lower. It can be attributed to the economic shock,
where the exchange rate not able to move immediately to its new long-rum normal value, but
overshoots beyond that point. It happens due ot the sticky prices and adjustment costs in the goods
and financial markets.

b) How does your answer about the short run behavior of the exchange rate modify if,
in addition to permanent increase in real money demand, output falls in the short
run?

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If the output falls in the short run, either due to demand shock or supply shock, it will cause a
decrease or downward pressure on the demand of money. Both industrial and domestic consumers
will reduce their transactions and precautionary demand for money would balance out. As a result,
exchange rate and interest rate will reduce in the short run, which will focus on increasing the
output and aggregate demand.

A fall in the domestic output level means that it is a sign for international investors that an economy
is doing poorly. As a result, their demand for the local currency would reduce in the short-term
which would show a fall in exchange rates. Secondly, with a fall in the output level, there won’t
be much to export which means that units of domestic currency won’t receive as much demand
from foreigners as they don’t have much stuff to buy from the local market. A different impact can
be in a situation where some local products are in excessive and high foreign demand but there is
a shortage of those products now due to a fall in the output level. In such cases, foreigners
interested to buy the product will offer exceptional prices to acquire them in the short run, until
they can find alternatives or substitutes for those products. In such a scenario, the demand for local
currency would increase, causing an appreciation of the exchange rate. Overshooting, therefore,
can be more volatile, drastic, and extensive as compared to the prior situation.

The situation can be considered a negative shock to the exchange rate where the money demand
has increased, net exports have increased, and output has decreased. In the short-term, the fall in
output reduces the demands for imports and increases net exports which can offset the fall in
aggregate demand. Price level is reduced which further causes a fall in the demand for money
balances. As a result, exchange rate would depreciate and interest rates to increase which can bring
back the long-term equilibrium.

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Question 2) Consider the monetary approach to the determination of the exchange rate.

[a]What is the effect on the price level, interest rate and exchange rate from a permanent
contraction in the domestic level of the money supply? [10 marks]

The supply of money in the economy would decrease. With fewer units of domestic currency
available, each single unit would become more valuable. As a result, the price level will decrease,
with the price of goods and services decreasing as well. It is due to the fact that consumers have
less money to spend,

Demand for money will remain the same, while the supply for money decreases. As a result, a
shortage of money will occur resulting in increased interest rates. Such an action would encourage
people to save and discourage them from borrowing, which would help in reducing inflationary
pressure. It will make it more expensive for borrowers to gain credit.

A permanent money supply contract will, in ceteris paribus situations, increase the value of the
domestic currency relative to other currencies. As a result, the exchange rate of the domestic
currency will appreciate. Foreign investors want to invest in the domestic currency, which would
lead to appreciation.

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[b] How does your previous answer modify if, instead of the level, it is the domestic growth
rate of the money supply that contracts permanently? [10marks]

It means that domestic money supply will increase in the future, but at a slower rate than before.
As a result, we can determine the following impacts. The rate of change of money supply is
affected instead of the absolute level of money supply.

Money supply would increase in the future, but at a slower rate than before. It means that each unit
of the currency will be less valuable in the future as more units will be available, As a result, the
price level would increase, but at a slower rate than before.

Demand for money remains the same, but the speed at which money supply increases will fall. As
a result, there will be a surplus of domestic currency in the market, which will reduce interest rates.
It would encourage people to borrow and spend, and savings would be reduced. As a result, the
inflationary pressure would increase as well. This will happen at a slower rate than before.

Finally, the value domestic currency will slowly fall relative to other currencies, which would
depreciate the interest rate of the domestic currency.

[c] How do your previous answers modify if we drop the assumption of PPP? [15 marks]

By dropping the assumption of PPP, the relationship between exchange rate and price level
becomes more complex. Without PPP, a change in the price level will not necessarily result in a
change in the exchange rate. As a result, a permanent contraction will still decrease the price level
and increase interest rates. However, the exchange rate effect will not be directly determinable as
before. Instead, other factors such as economic fundamentals, political stability and market
sentiment may have to be considered. Exchange rate may not fully reflect a change in the price
level and interest rates due to contract of money supply. More volatility may be expected in the
exchange rate as market participants will base their expectations on other factors, which could
result in different adjustments. Without PPP, long run average prices do not immediately adjust
even if expectations of inflation adjust. Therefore, it may undershoot in the long run with a fall in
money supply.

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[d] Finally, how does your previous answer modify if, in addition to the contraction of the
level or the growth of the money supply, the relative demand of domestic goods increases?

An increase in relative demand for domestic goods and services would increase the aggregate
demand. Therefore, it could either offset the decrease in the aggregate demand that occurred due
to contraction in money supply or go beyond just reversing it. It would depend on how extensively
the demand for domestic goods has increased. As a result, the decrease in price level would be less
pronounced, as increased demand could put upward pressure on the prices. The increase in the
interest rates that occurred due to the contraction in the money supply may also be offset as the
business can find it easier to pass their higher borrowing costs on to the customers. Another
scenario can be where extensive demand may result in demand pull inflation where interest rates
would have to increase to cut borrowing. Regarding exchange rates, if the increase in demand for
domestic goods has a greater impact than the contraction in money supply, the exchange rates
would appreciate as foreign investors would require domestic currency to invest in the domestic
economy to take greater benefit of the increased demand. At the same time, they may want to
import domestic goods, which would increase demand for domestic currency as well. On the other
hand, if the contraction in money supply is more significant, then the exchange rate may depreciate
as foreign investors would go away, and due to market forces, the supply would be greater than
demand, lowering the currency’s value.

[15 marks] Supplement your answer with a carefully explained diagrammatic analysis.
(1000-word limit)