2. Use the money market and foreign exchange

(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 increase in India’s money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.

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/$.

c. Using your previous analysis, state how each of the following variables changes in the short run (increase/decrease/no change):

India’s interest rate iRs, ERs/$, expected exchange rate Ee Rs/$, and price level PIN.

d. Using your previous analysis, state how each of the following variables changes in the long run (increase/decrease/no change relative to their initial values at point A): India’s interest rate iRs, ERs/$, Ee Rs/$, and India’s price level PIN.

e. Explain how overshooting applies to this situation.