Summary of how the monetary model works.pdf - 1 Starting from initial long run equilibrium Money market equilibrium 1 Goods market equilibrium AD = Y

Summary of how the monetary model works.pdf - 1 Starting...

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1. Starting from initial long run equilibrium Money market equilibrium, 𝑀𝑀 1 𝑃𝑃 1 = 𝐿𝐿 𝑌𝑌 𝑀𝑀 1 𝑃𝑃 1 = 𝐿𝐿 𝑌𝑌 Goods market equilibrium, AD = Y AD* = Y* Exchange rate at PPP level: 𝑃𝑃 1 = 𝐸𝐸 1 𝑃𝑃 1 or 𝐸𝐸 1 = 𝑃𝑃 1 𝑃𝑃 1 2. Consider an increase in the domestic money supply from M 1 to M 2 : 𝑀𝑀 2 𝑃𝑃 1 > 𝐿𝐿 𝑌𝑌 This causes excess supply in the domestic money market and excess demand in the domestic goods market P above P 1 We will see below that P will eliminate the excess demand in the goods market (since P leads to quantity of AD ) and the excess supply in the money market (since P reduces real money supply). 3. As P above P 1 PPP is violated. P > 𝐸𝐸 1 𝑃𝑃 1 Since the monetary model assumes PPP must hold, the above situation is not possible. P > 𝐸𝐸 1 𝑃𝑃 1 would trigger goods market arbitrage.
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