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Chapter 15 Essays and Answers

Money serves in general three important functions: a medium of exchange; a unit of account;
and a store of value. As a medium of exchange, money avoids going back to a barter economy,
with the enormous search costs connected with it. As a unit of account, the use of money

economizes on the number of prices an individual faces. Consider an economy with N goods,
then one needs only (N - 1) prices. As a store of value, the use of money in general ensures that
you can transfer wealth between periods.

2. 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.
3. Explain the exchange rate over-shooting hypothesis.

Answer: Many prices in the economy are written into long-term contracts and cannot be

changed immediately when changes in the money supply occur. A permanent increase in M,
holding P constant, increases the real money supply (M/P) and lowers the nominal interest rate
(R). This shifts the dollar return schedule left. A permanent increase in M also creates the

expectation that in the long run all prices including the exchange rate would rise. A rise in the
expected exchange rate shifts the foreign schedule right. Therefore, in the short run
equilibrium is established at point 2 In the long run the price level adjusts and rises

proportionately with the money supply. Therefore, M/P and R return to their initial levels in the
long run and the equilibrium exchange rate is determined at point 3. In other words, the

exchange rate first overshoots and then returns to its long run level. Therefore, the fluctuations
in E are much stronger than those of P.

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 1' to point
2' 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 2' to 4'). So a
large depreciation (from Point 1' in the left upper figure to pint 2' in both the left and right
upper figures) is followed by an appreciation of the dollar (the movement from 2' to point 4' 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 3' and 4' represent the
same exchange rate.
5. Using 4 different figures, plot the time paths showing the effects of a permanent increase in
the United States money supply on:
(a) U.S. Money supply

(b) The dollar interest rate.

(d) The dollar/euro exchange rate