Economics 236/336 Fall 2024 - 2025

American University of Beirut

Department of Economics
Economics 236/336

Week 5 Tutorial - Solutions

Exchange Rates II: The Asset Approach in the Short Run

1. Use the money market and FX diagrams to answer the following questions about the relationship between
the British pound (£) and the U.S. dollar ($). The exchange rate is in U.S. dollars per British pound
E$/£ . 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.

See the following diagram.

(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, the exchange rate E$/£ , the
e
expected exchange rate E$/£ , and the U.S. price level PU S .

e
The U.S. interest rate decreases, the British interest rate does not change, E$/£ increases, E$/£ does
not change, and the U.S. price level does not change.

(c) 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
e
interest rate, the exchange rate E$/£ , the expected exchange rate E$/£ , and the U.S. price level PU S .

All of the variables return to their initial values in the long run. This is because the shock is temporary,
implying the central bank will increase the money supply from M 1 to M 2 in the long run.

1
Economics 236/336 Fall 2024 - 2025

2. Use the money market and FX diagrams to answer the following questions. This question considers the
relationship between the Indian rupee (Rs) and the U.S. dollar ($). The exchange rate is in rupees per
dollar, ERs/$ . On all graphs, label the initial equilibrium point A.

(a) Illustrate how a permanent decrease in Indias money supply affects the money and FX markets.
Label your short-run equilibrium point B and your long-run equilibrium point C.

See the following diagram. Thick arrows indicate temporary movement while thinner ones indicate
the movements in the long run. In the short run, prices are fixed. Therefore, the real money supply
changes from M S 1 to M S 2 , thus temporarily raising the domestic interest rate. In the long run,
as prices rise, the real money supply and interest rate return to their original level. In the foreign
exchange market, F R shifts to the right and stays there permanently because of an expected appreci-
ation of rupees.

(b) By plotting them on a chart with time on the horizontal axis, illustrate how each of the following
variables changes over time (for India): nominal money supply MIN , price level PIN , real money
supply MIN /PIN , interest rate iRs , and the exchange rate ERs/$ .

See the following diagrams where the change occurs at time T and variables have converged to their
long run value by time T + N .

2
Economics 236/336 Fall 2024 - 2025

(c) Using your previous analysis, state how each of the following variables changes in the short run
(increase/decrease/no change): Indias interest rate iRs , the exchange rate ERs/$ , expected exchange
e
rate ERs/$ , and price level PIN .

e
Indias interest rate increases, the U.S. interest rate remains unchanged, ERs/$ decreases, ERs/$ de-
creases, and Indias price level remains unchanged.

(d) Using your previous analysis, state how each of the following variables changes in the long run (in-
crease/decrease/no change relative to their initial values at point A): Indias interest rate iRs, the
e
exchange rate ERs/$ , the expected exchange rate ERs/$ , and Indias price level PIN

3
Economics 236/336 Fall 2024 - 2025

Indias interest rate remains unchanged, the U.S. interest rate remains unchanged, ERs/$ decreases,
e
ERs/$ decreases (remains unchanged in transition from short to long run), and Indias price level
decreases.

(e) Explain how overshooting applies to this situation.

e
The short-run exchange rate overshoots its long-run value, ERs/$ . We can see this in the impulse
response diagrams shown previously. The overshooting is caused by the investors adjustment of ex-
change rate expectations coupled with lower domestic interest rates. Since the rupee interest rate
rises, investors must be compensated by a rupee depreciation for UIP with U.S. interest rates to hold.
For a rupee depreciation to be possible, it must depreciate more in the short run than its longer-run
value.

3. Use the money market and FX diagrams to answer the following questions. This question considers the
relationship between the euro (e) and the U.S. dollar ($). The exchange rate is in U.S. dollars per euro,
E$/e . Suppose that with financial innovation in the United States, real money demand in the United
States decreases. On all graphs, label the initial equilibrium point A.

(a) Assume this change in U.S. real money demand is temporary. Using the FX/money market diagrams,
illustrate how this change affects the money and FX markets. Label your short-run equilibrium point
B and your long-run equilibrium point C.

See the following diagram. The long-run values are the same as the initial values because the shock is
temporary. Also because the shock is temporary, we assume that the reversal of real money demand
occurs before the price level adjuststhat is, M D returns from M D2 to M D1 before the price level
changes.

(b) Assume this change in U.S. real money demand is permanent. Using a new diagram, illustrate how
this change affects the money and FX markets. Label your short-run equilibrium point B and your
long-run equilibrium point C.

See the following diagram. In the long run, the price level will have to increase to adjust for the drop
in real money demand (assuming the central bank does not change the money supply M). That is,
the nominal interest rate returns to its initial value in the long run. This requires that the price level
increase to reduce real money supply. The drop in real money demand will have to be met one-for-
one with a drop in real money supply (generated by an increase in the price level). In this case, the

4
Economics 236/336 Fall 2024 - 2025

expected exchange rate changes because the shock is permanent. Therefore, the FR schedule in the
forex market also shifts upward.

(c) Illustrate how each of the following variables changes over time in response to a permanent reduction
in real money demand: nominal money supply MU S , price level PU S , real money supply MU S /PU S ,
U.S. interest rate i$ , and the exchange rate E$/e .

See the following diagrams.

5
Economics 236/336 Fall 2024 - 2025

4. This question considers how the FX market will respond to changes in monetary policy in South Korea.
For these questions, define the exchange rate as South Korean won per Japanese yen, Ewon/Y . Use the FX
and money market diagrams to answer the following questions. On all graphs, label the initial equilibrium
point A.

(a) Suppose the Bank of Korea permanently increases its money supply. Illustrate the short-run (label
equilibrium point B) and long-run effects (label equilibrium point C) of this policy.

See the following diagram. In the short run, prices are fixed. Therefore, the real money supply changes
from M S 1 to M S 2 , thus temporarily raising the South Korean interest rate. In the long run, as prices
rise, the real money supply and interest rate return to their original levels. In the foreign exchange
market, FR shifts to the right and stays there permanently because of an expected depreciation of won.

(b) Now, suppose the Bank of Korea announces it plans to permanently increase its money supply but
doesnt actually implement this policy. How will this affect the FX market in the short run if investors
believe the Bank of Koreas announcement?

See the following diagram. In this case, interest rates on won-denominated deposits dont change be-
cause the Bank of Korea doesnt cut the money supply. However, because investors expected the Bank
of Korea to cut the money supply, they expect the won will depreciate relative to the yen, causing a
decrease in the return on yen-denominated deposits in the short run. Notice the resulting change in
the exchange rate is relatively small (compared with the dramatic decrease we see in [a]).

6
Economics 236/336 Fall 2024 - 2025

(c) Finally, suppose the Bank of Korea permanently increases its money supply, but this change is not
anticipated. When the Bank of Korea implements this policy, how will this affect the FX market in
the short run?

In this case, the expected exchange rate is unchanged because the investors didnt expect the increase
in the money supply. As such, the FR line does not shift.

(d) Using your previous answers, evaluate the following statements:

• If a country wants to decrease the value of its currency, it can do so (temporarily) without
lowering domestic interest rates.
• The central bank can increase both the domestic price level and value of its currency in the long
run.
• The most effective way to decrease the value of a currency is through surprising investors.

Though it is theoretically possible, as shown in (b), it is not a good policy because it is bad for the
policy makers reputation in the long run.
• True. In (b) we see a depreciation of the South Korean won relative to the Japanese yen without
an interest rate change. The opposite of such a policy could achieve this.
• False; shown in (a). An increase in price level implies an exchange rate depreciation by PPP.
• False; shown in (b) and (c) compared with (a). The most dramatic depreciation of the won
occurs when the increase in M is coupled with investors anticipating the depreciation of the
won. In general, a policy must be credible for it to have an effect in the long run. The effects
of unanticipated policies as in (b) and (c) will fade quickly as foreign investors update their
expectations after the policy change.

5. In the late 1990s, several East Asian countries used limited flexibility or currency pegs in managing their
exchange rates relative to the U.S. dollar. This question considers how different countries responded to
the East Asian currency crisis (19971998). For the following questions, treat the East Asian country as
the home country and the United States as the foreign country. Also, for the diagrams, you may assume
these countries maintained a currency peg (fixed rate) relative to the U.S. dollar. Also, for the following
questions, you need consider only the short-run effects.

7
Economics 236/336 Fall 2024 - 2025

(a) In July 1997, investors expected that the Thai baht would depreciate. That is, they expected that
Thailands central bank would be unable to maintain the currency peg with the U.S. dollar. Illustrate
how this change in investors expectations affects the Thai money market and FX market, with the
exchange rate defined as baht (B) per U.S. dollar, denoted EB/$ . Assume the Thai central bank
wants to maintain capital mobility and preserve the level of its interest rate, and abandons the cur-
rency peg in favor of a floating exchange rate regime.

If Thailand is willing to let its currency float against the dollar, then Thailands central bank can
maintain monetary policy autonomy and international capital mobility. See the following diagram:

(b) Indonesia faced the same constraints as Thailandinvestors feared Indonesia would be forced to aban-
don its currency peg. Illustrate how this change in investors expectations affects the Indonesian
money market and FX market, with the exchange rate defined as rupiahs (Rp) per U.S. dollar, de-
noted ERp/$ . Assume that the Indonesian central bank wants to maintain capital mobility and the
currency peg.

If Indonesia wants to maintain the currency peg against the dollar and maintain international capital
mobility, it will have to give up monetary policy autonomy. In this case, Indonesia has to increase
the domestic interest rate to keep investors from dumping their rupiah-denominated deposits for U.S.
dollars and moving their investments out of Indonesia (this would then cause a depreciation in the
rupiah).

8
Economics 236/336 Fall 2024 - 2025

(c) Malaysia had a similar experience, except that it used capital controls to maintain its currency peg
and preserve the level of its interest rate. Illustrate how this change in investors expectations affects
the Malaysian money market and FX market, with the exchange rate defined as ringgit (RM) per
U.S. dollar, denoted ERM/$ . You need show only the short-run effects of this change in investors
expectations.

See the following diagram. In the absence of capital controls, the Malaysian interest rate would have
to rise. However, by preventing investors from taking advantage of arbitrage, Malaysia creates a
disequilibrium. The investors require i2RM to keep their deposits in Malaysia, but they receive only
i1RM . Because of the capital controls imposed by Malaysia, investors cannot withdraw their ringgit-
denominated deposits (selling ringgit in exchange for dollars in the FX market). In effect, the foreign
market equilibrium diagram shown below does not work/exist. This allows Malaysia to maintain mon-
etary policy autonomy and a fixed exchange rate at the same time.

(d) Compare and contrast the three approaches just outlined. As a policymaker, which would you favor?
Explain.

There is no correct answer to this question. The cases above highlight the trilemma because each
country can choose a different option depending on its domestic or international priorities. Each
country needs to compare the benefits of having any two of (a) fixed exchange rates, (b) monetary
autonomy, and (c) international capital mobility against the cost of not having the third one.

6. Several countries have opted to join currency unions. Examples include those in the euro area, the CFA
franc union in West Africa, and the Caribbean currency union. This involves sacrificing the domestic cur-
rency in favor of using a single currency unit in multiple countries. Assuming that once a country joins a
currency union, it will not leave, do these countries face the policy trilemma discussed in the text? Explain.

These countries do face the trilemma because they are committed to maintaining the first policy goal of
a fixed exchange rate. Joining a currency union effectively means a country has a fixed exchange rate
without the need for government intervention because the money supply is controlled by a regional central
bank for member countries. This effectively reduces the choice to a dilemma between monetary policy
autonomy versus international capital mobility. Typically, countries that are part of a currency union
sacrifice monetary policy autonomy; policy decisions are made jointly rather than independently.