N2

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.

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$/, the expected exchange rate E$/e, and the U.S. price level PUS.