Q. To answer the following question, please refer to the figure below. Concentrating only at the lower left quadrant, discuss the relationship between the U.S. real money supply and the dollar/euro exchange rate, E_{$/E}.
Answer: The lower left quadrant in the figure described the PPP (Purchasing Power Parity) relationship. The relationship with the U.S real money supply and the dollar/euro exchange rate E_{$/E} is negative.s
E_{$/E} is equal to the price level ratio PUS/ PE in this derivation of the relationship the following variables are assumed constants,
M1_{US}, R_{E}, and P_{E}
So, E_{$/E} = M1_{US}/P_{US}
The raise in P_{US} leads to a positive increase in E_{$/E}.
P1_{US} will shift to P2_{US}
Therefore the purchasing power of the dollar decreases because of the increase in the price level.
E1_{$/E} will shift to E2_{$/E}
Explicitly the dollar depreciates due to PPP.