Assume that output is fixed.

(a) Suppose there is a permanent reduction in aggregate real money demand, that is, a permanent negative shift in the aggregate real money demand function.

(i) With the help of the combined money market and foreign exchange market diagram, analyze how exchange rate and interest rate change in the short run and the long run.

(ii) Draw four diagrams showing the time trajectory of the exchange rate, interest rate, price level and money supply respectively.

(b) Suppose the reduction is aggregate real money demand is temporary instead.

(i) What are the short run effects on the exchange rate and the interest rate?

(ii) Draw four diagrams showing the time trajectory of the exchange rate, interest rate, price level and money supply respectively.

(c) Compare the short run effects on the exchange rate and interest rate between the two types of changes in (a) and (b) above.