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Working group 3 19-09-2019Question 1 (chapter 15, problem 1)
Suppose there is a reduction in aggregate real money demand, that is, a negative shift in
the aggregate real money demand function. Trace the short-run and long-run effect on
the exchange rate, interest rate, and the price level.
Answer:
Short run:
Money demand decrease Interest rate decrease (domestic) Domestic return
decrease Expectations on foreign deposits return increase Exchange
depreciate
People have more money now, they will buy more bonds, price will rise, interest
rate decrease
PB = X/(1+R)
the gap between money supply and money demand is reduced until the new
point of intersection.
Home currency appreciate, foreign currency depreciates (temporary shock)
If we know there is a depreciation in the future, we expect it today or tomorrow.
Depreciation of the home currency appreciation of the foreign currency
We want to go back to the old interest rate real money supply goes down
prices go up
In the long run, prices will cause the adjustment.
Money supply increase is the same as a money demand decrease.
More money sell bonds interest rate goes back to the old one
Currency goes up: appreciation of the home currency
Money supply is permanently increased, expected depreciation will stay.
Price level = constant
Long run:
Price Level decrease Interest rate decrease (domestic) Domestic return
decrease Exchange depreciate
What is given?
Reduction in aggregate real money demand
What is asked?
Short run effects on: exchange rate, interest rate, price level
Long run effects on: exchange rate, interest rate, price level
What do we know?
Here: which model and analysis is use?
For short run: money market and foreign exchange market model
For the long: nominal neutrality from monetary model
Long run is where everything gets permanent P adjusts, and exp. e adjusts.
The expected exchange rate is an expected depreciation, this means an expected appreciation of the foreign
currency (shift outwards of the foreign return curve).
, short run (P fixed and exp e adjusts)
long run, price adjusts, interest rate goes back to the old level.
Overshooting: you go up/down, but not as much as in the beginning.
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