Assume that Janet Yellen (chair of the US Fed Reserve) decides to reduce the US
ID: 1195636 • Letter: A
Question
Assume that Janet Yellen (chair of the US Fed Reserve) decides to reduce the US money supply (i.e., contractionary monetary policy).
1) Using the concept of money market equilibrium, explain what will happen to interest rates and prices in the U.S. in the short-run.
2) Using the concept of interest-rate parity explain what will happen to the exchange rate of the dollar in the short-run (i.e., will it appreciate or depreciate?).
3) Given your answers to (1) and (2), do you think this policy is designed to stimulate the economy (i.e., increase production in the U.S. in the short-run)? Explain.
4) Using the concept of money market equilibrium, explain what will happen to interest rates and prices in the U.S. in the long-run.
5) Using the concept of purchasing-power parity explain what will happen to the exchange rate of the dollar in the long-run (i.e., will it appreciate or depreciate?).
6) Given your answers to (4) and (5), do you think this policy is designed to stimulate the economy (i.e., increase production in the U.S. in the long-run)? Explain.
Explanation / Answer
1) Due to decrease in money supply the interest rate would go up and the prices will go down. As money supply is inversely proportional to interest rate and dirctly proportional to price.
2) We know, Equilibrium condition is: Expected return on domestic asset - Expected return on foreign asset
i = if - (change)EXe / EX
Since, i goes up , the money supply goes down , which means dollar has reduced in the market. We can say that the value of dollar has appreciated.
3) Yes, the policy is designed to strengthen the economy as the value of dollar will be appreciated by this move.
4) In the long run, the intrest rate would come down to equlibrium unless money suplly equals money demanded . As a result in the long run dollar value will depriciate.
5) Exchange rate in the long run will come down as the value of dollar will depriciate.
6) Yes, the policy is designed to stimulate the economy as the value of dollar and echange rate achieve equilibrium.
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