Consider the relationship between the Japanese yen () and U.S. dollar ($). Let the exchange rate be defined as $ per , E$/. Apply the money market foreign exchange market diagrams to answer the following questions. On all graphs, label the initial equilibrium point A.

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

2) Refer to the diagram from (1), state how each of the following variables changes in the short run (increase/decrease/no change): U.S. interest rate, Japanese interest rate, spot exchange rate E, expected future exchange rate F, and U.S. price level.

3) Refer to the diagram from (1), 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, Japanese interest rate, E, F, and U.S. price level.

4) Suppose the decrease in Japans money supply is considered as permanent and monetary policy is credible. Would the exchange rate overshoot in the short run? Apply the money market foreign exchange market diagram to analyzing the short-run exchange rate equilibrium and long-run adjustments of Japanese price level and exchange rate.

5) According to the PPP theory of long run exchange rate determination, what would happen to exchange rate if money supply is decreasing permanently, is it consistent with the mechanism of long-run adjustment in (4)?