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Chapter 15. Chapter 15

Work It Out
Chapter 15
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You must read each slide, and complete any questions on the slide, in sequence.

Use the money market and FX diagrams to answer the following questions about the relationship between the British pound (£) and the U.S. dollar ($). The exchange rate is in U.S. dollars per British pound expected dollar-pound exchange rate . We want to consider how a change in the U.S. money supply affects interest rates and exchange rates. On all graphs, label the initial equilibrium point A.

a. Illustrate how a temporary increase in the U.S. money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
Video transcript

Work It Out, Chapter 15, Question 1

(Transcript of audio with descriptions. Transcript includes narrator headings and description headings of the visual content)

(Speaker)
We want to consider how a change in the U.S. money supply affects interest rates and exchange rates. The exchange rate is in U.S. dollars per British pound. Use the money market and FX diagrams to answer the following questions about the relationship between the British pound and the U.S. dollar. On all graphs, label the initial equilibrium point A. Start by drawing the money market diagram. On the y axis we have the interest rate in the United States, and on the x axis the real money in the United States.

(Description)
A coordinate plane with the horizontal x-axis and the vertical y-axis is drawn on the left part of the slide. The horizontal axis is labeled M subscript US over P subscript US. The vertical axis is labeled i subscript the dollar sign.

(Speaker)
Draw the money foreign exchange diagram. On the y axis we have the expected return and on the x axis the U.S. dollars per British pound exchange rate.

(Description)
A coordinate plane with the horizontal x-axis and the vertical y-axis is drawn on the right part of the slide. The horizontal axis is labeled E subscript the dollar sign over the pound sign. The vertical axis is labeled ER.

(Speaker)
Draw the money supply MS1 (since it is controlled by the Fed, it is perfectly inelastic, a vertical line), and the money demand MD1 and label them. At their intersection we find the equilibrium interest rate i1.

(Description)
On the left plane, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It is labeled MD subscript 1. Another straight line which is parallel to the vertical axis, is drawn. It is labeled MS subscript 1. Point, i superscript 1 subscript the dollar sign, is labeled on the vertical axis. There is a dotted line extending from this point, which is parallel to the horizontal axis. Three lines intersect at point A.

(Speaker)
Draw the dollar return (horizontal) and label it. Draw the foreign return curve and label it. At their intersection we find the equilibrium exchange rate.

(Description)
On the right plane, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It is labeled FR subscript 1. Another straight line which is parallel to the horizontal axis, is drawn. It is labeled DR subscript 1. Point, E superscript 1, is labeled on the horizontal axis. There is a dotted line extending from this point, which is parallel to the vertical axis. Three lines intersect at point A.

(Speaker)
An increase in the money supply will shift the MS curve from MS1 to MS2. The new money supply is MS2. As a result, the interest rate drops, from i1 to i2.

(Description)
Point, MS subscript 2, is labeled on the horizontal axis, so that MS subscript 2 is larger than MS subscript 1. An arrow pointing from point, MS subscript 1 to point, MS subscript 2, is drawn. A straight line extending from point, MS subscript 2, which is parallel to the vertical axis, is drawn. Point, i superscript 2 subscript the dollar sign, is labeled on the vertical axis. There is a dotted line extending from this point, which is parallel to the horizontal axis. This dotted line intersects with lines, MS subscript 2, and MD subscript 1, at point B.

(Speaker)
As a result of a lower interest rate, the dollar return will decrease from DR1 to DR2. Accordingly, the exchange rate will increase from E1 to E2. The dollar will depreciate.

(Description)
A straight line which is parallel to the vertical axis is drawn. It is labeled DR subscript 2. It is below line DR subscript 1. An arrow pointing from line, DR subscript 1, to line, DR subscript 2, is drawn. Point, E superscript 2, is labeled on the horizontal axis, so that E superscript 2 is larger than E superscript 1. An arrow pointing from point, E superscript 1 to point, E superscript 2, is drawn. There is a dotted line extending from point, E superscript 2, which is parallel to the vertical axis. This dotted line intersects with lines, DR subscript 2, and FR subscript 1, at point B.

(Speaker)
As soon as the money supply is reversed to the initial value, the process reverses as well. The system reaches the original equilibrium where A equals C.

(Description)
The arrows pointing from point, MS subscript 1, to point, MS subscript 2, from point E superscript 1, to point, E superscript 2, as well as from line, DR subscript 1, to line, DR subscript 2, are transformed in the opposite way.

b. Using your diagram from (a), state how each of the following variables changes in the short run (increase/decrease/no change): U.S. interest rate, British interest rate dollar-pound exchange rate , expected dollar-pound exchange rate , and the U.S. price level P.
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      Video transcript

      Work It Out, Chapter 15, Question 2

      (Transcript of audio with descriptions. Transcript includes narrator headings and description headings of the visual content)

      (Speaker)
      Question (b) will ask you to state how the U.S. interest rate, British interest rate, dollar per pound exchange rate, expected dollar per pound exchange rate, and U.S. price level changes in the short run (increase/decrease/no change).

      (Description)
      The initial graphs from question a are shown.

      (Speaker)
      Since the money supply increases, more money will be available on the U.S. market, and the U.S. interest rate will decrease from i1 to i2. The British interest rate is not affected by the increase in the U.S. money supply. Since the decrease in the U.S. interest rate will affect the dollar return, which will also decrease, investors will move their money out of the United States, and the dollar per pound exchange rate will increase from E1 to E2, which is a dollar depreciation. The expected dollar per pound exchange rate will not change because the changes are temporary. The U.S. price level will not change in the short run.

      Using your diagram from (a), state how each of the following variables changes in the long run (increase/decrease/no change relative to their initial values at point A): U.S. interest rate, British interest rate, dollar-pound exchange rate , expected dollar-pound exchange rate , and U.S. price level P.





      Video transcript

      Work It Out, Chapter 15, Question 3

      (Transcript of audio with descriptions. Transcript includes narrator headings and description headings of the visual content)

      (Speaker)
      Question (c) will ask how the U.S. interest rate, British interest rate, dollar per pound exchange rate, expected dollar per pound exchange rate, and U.S. price level P change in the long run (increase/decrease/no change relative to their initial values at point A).

      (Description)
      The graphs from question a with the inverted arrows are shown.

      (Speaker)
      As the money supply decreases from MS2 toward the original value MS1, the U.S. interest rate increases from i2 to i1, leading to no change in the initial value. The British interest rate is not affected by the change in the U.S. money supply. Since the dollar return increases toward the original value, the dollar per pound exchange rate will decrease from E2 to E1. Thus in the long run, there is no change from the initial value. The expected exchange rate does not change. The U.S. price level will not change.