Homework2-ANSWERS - money demand, leaving all relative...

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An increase in the money demand, in short term, has the same effects as a decrease in the money supply. In the previous figure the increase in the money demand is depicted as a upward shift in the money demand schedule from L1 to L2. The immediate effect of this is the increase in the interest rate and an appreciation of the exchange rate from E1 to E2, if the increase in money demand is temporary or an apppreciation to E3 if the increase is permanent. The larger impact effect of a permanent increase in money demand arises because the change also affects the future exchange rate expected in the foreign exchange market. In the long run , the price level decrease to bring the real money supply into line with real
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Unformatted text preview: money demand, leaving all relative prices, output and the nominal interest rate the same and apreciation the domestic currency in proportion to the increase in real money demand. The long run level balances is M/P 2 , a level where the interest rate in the long run equals its initial value. The dynamics of adjustment to a permanent increase in money demand are from the initial point where exchange rate is E1, immediately to point where the exchange rate is E3, and then, as the price level falls over time, to the new long run position with an exchange rate of E4. R L2 L1 E1 E4 E2 E3...
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