5. (20 points) Money Market and Exchange Rate

(1) Explain how the money markets of two countries are linked though the foreign exchange market.

(2) The following Figure shows the effect on the Dollar/Euro exchange rate and the Dollar interest rate after an increase in the U.S. money supply. Please explain why the dollar depreciates against the euro in this case.

Dollar/euro exchange rate. Este Este Dollar return Dollar return 2 2 3 Expected euro return ERE Expected euro return ESE Rates of return (in dollar terms) R R? RS 1 L(RS. Yus) MUS LIR. Yus) 4 U.S. real money supply PUs Muis 1 US 1 Mus PS NO 2 PUS U.S. real money holdings (a) Short-run effects U.S. real money holdings (b) Adjustment to long-run equilibrium