ECN209

PROBLEM SET 4
SUGGESTED SOLUTIONS

1. Between 1984 and 1985, the money supply in the United States increased to $641.0 billion from 570.3
billion, while that of Brazil increased to 106.1 billion cruzados from 24.4 billion. Over the same period,
the U.S. consumer price index rose to 100 from a level of 96.6, while the corresponding index for Brazil
rose to 100 from a level of only 31. Calculate the 1984–1985 rates of money supply growth and inflation
for the United States and Brazil, respectively. Assuming that other factors affecting the money markets
did not change too dramatically, how do these numbers match up with the predictions of this chapter’s
model? How would you explain the apparently different responses of U.S. compared with Brazilian
prices?

Answer: The 1984 - 1985 money supply growth rate was 12.4 percent in the United States (100%·(641.0
- 570.3)/570.3) and 334.8 percent in Brazil (100%·(106.1 - 24.4)/24.4). The inflation rate in the United
States during this period was 3.5 percent and in Brazil the inflation rate was 222.6 percent. The change
in real money balances in the United States was approximately 12.4% - 3.5% = 8.9%, while the change
in real money balances in Brazil was approximately 334.8% - 222.6% = 112.2%. The small change in
the U.S. price level relative to the change in its money supply as compared to Brazil may be due to greater
short-run price stickiness in the United States; the change in the price level in the United States represents
28 percent of the change in the money supply ((3.5/12.4)·100%) while in Brazil this figure is 66 percent
((222.6/334.8) ·100%). There are, however, large differences between the money supply growth and the
growth of the price level in both countries.

2. 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 effects on the exchange rate, interest
rate, and price level.

Answer: A reduction in real money demand has the same effects as an increase in the nominal money
supply. In figure 14.1, the reduction in money demand is depicted as a backward shift in the money
demand schedule from L1 to L2. The immediate effect of this is a depreciation of the exchange rate
from E1 to E2, if the reduction in money demand is temporary, or a depreciation to E3 if the reduction
is permanent. The larger impact effect of a permanent reduction in money demand arises because this
 change also affects the future exchange rate expected in the foreign exchange market. In the long run,
the price level rises to bring the real money supply into line with real money demand, leaving all
relative prices, output, and the nominal interest rate the same and depreciating the domestic currency in
proportion to the fall in real money demand. The long-run level of real balances is (M/P2), a level
where the interest rate in the long-run equals its initial value. The dynamics of adjustment to a
permanent reduction in money demand are from the initial point 1 in the diagram, where the exchange
rate is E1, immediately to point 2, where the exchange rate is E3 and then, as the price level falls over
time, to the new long-run position at point 3, with an exchange rate of E4.

3. Explain the effects of a permanent increase in the U.S. money supply in the short run and in the long run.
Assume that the U.S. real national income is constant.

Answer: An increase in the nominal money supply raises the real money supply, lowering the interest
rate in the short run. The money supply increase is considered to continue in the future; thus, it will affect
the exchange rate expectations. This will make the expected return on the euro more desirable and thus
the dollar depreciates. In the case of a permanent increase in the U.S. money supply, the dollar depreciates
more than under a temporary increase in the money supply.
Now, in the long run, prices will rise until the real money balances are the same as before the permanent
increase in the money supply. Since the output level is given, the U.S. interest rate, which decreased
before, will start to increase, until it will move back to its original level. The equilibrium interest rate
must be the same as its original long run value. This increase in the interest rate must cause the dollar to
appreciate against the euro after its sharp depreciation as a result of the permanent increase in the money
supply. So a large depreciation is followed by an appreciation of the dollar. Eventually, the dollar
depreciates in proportion to the increase in the price level, which in turn increases by the same proportion
as the permanent increase in the money supply. Thus, money is neutral, in the sense that it cannot affect,
in the long run, real variables, such as output, investment, etc.

4. Using figures for both the short run and the long run, show the effects of a permanent increase in the U.S.
money supply. Try to line up your figures to the short and long run equilibria side by side. Assume that
the U.S. real national income is constant.

Answer: An increase in the nominal money supply raises the real money supply, lowering the interest
rate in the short run (the movement from 1 to 2 on the lower left figure). The money supply increase is
considered to continue in the future, and thus it will affect the exchange rate expectations. This will make
the expected return on the euro more desirable and thus the dollar depreciates. In the case of a permanent
increase in the U.S. money supply, the dollar depreciates more than under a temporary increase in the
money supply (from point to point in the upper left figure).
Now, in the long run, (the right hand side figure), prices will rise until the real money balances are the
same as before the permanent increase in the money supply (from point 2 to point 4, in the lower right
figure). Since the output level is given, the U.S. interest rate which decreased before, will start to increase,
until it will move back to its original level (from Point 2 to 4 in the lower left figure). The equilibrium
interest rate must be the same as its original long run value (at point 4 in the lower right figure). This
increase in the interest rate must cause the dollar to appreciate against the euro after its sharp depreciation
as a result of the permanent increase in the money supply (this process is depicted in the upper right
figure from point to ). So a large depreciation (from Point in the left upper figure to pint in both
the left and right upper figures) is followed by an appreciation of the dollar (the movement from to
point in the upper right hand side figure). Eventually, the dollar depreciates in proportion to the
increase in the price level, which in turn increases by the same proportion as the permanent increase in
the money supply. Thus, money is neutral, in the sense that it cannot affect, in the long run, real variables,
such as output, investment, etc. Note that points and represent the same exchange rate.
5. [Difficult question] In our discussion of short-run exchange rate overshooting, we assumed that real
output was given. Assume instead that an increase in the money supply raises real output in the short run.
How does this affect the extent to which the exchange rate overshoots when the money supply first
increases? Is it likely that the exchange rate undershoots? (Hint: In Figure 15-12a in the book, allow the
aggregate real money demand schedule to shift in response to the increase in output.)

Answer: If an increase in the money supply raises real output in the short run, then the fall in the interest
rate will be reduced by an outward shift of the money demand curve caused by the temporarily higher
transactions demand for money. In figure 14-3, the increase in the money supply line from (M1/P) to
(M2/P) is coupled with a shift out in the money demand schedule from L1 to L2. The interest rate falls
from its initial value of R1 to R2, rather than to the lower level R3, because of the increase in output and
the resulting outward shift in the money demand schedule. Because the interest rate does not fall as much
when output rises, the exchange rate depreciates by less: from its initial value of E1 to E2, rather than to
E3, in the diagram. In both cases we see the exchange rate appreciate back some to E4 in the long run.
The difference is the overshoot is much smaller if there is a temporary increase in Y.
Undershooting occurs if the new short-run exchange rate is initially below its new long-run level. This
happens only if the interest rate rises when the money supply rises – that is if GDP goes up so much that
R does not fall, but increases. This is unlikely because the reason we tend to think that an increase in M
may boost output is because of the effect of lowering interest rates, so we generally don’t think that the
Y response can be so great as to increase R.