Q. To answer the following question, please refer to the figure below. Concentrating only at the lower right quadrant, discuss the effects of a change in U.S. expected inflation.

Answer: The lower right quadrant illustrates the equilibrium in the U.S Money Market where

R1$ = M1US/P1US.

A known interest rate R1$ corresponds with a given U.S real money supply M1US/P1US

Consider a increase of in the future rate of U.S money supply growth that is an increase in the expected rate of inflation.

The Key Point- The increase in expected future inflation generates expectations of more rapid currency depreciation in the future.

Under Purchasing Power Parity (PPP) the dollar now depreciates at a rate of _ + . Interest parity thus requires the dollar interest rate to rise where

R2$ = R1$ + . Note: R$ - RE= _eUS - _eE

This relation illustrate a change in the U.S interest rate because of an increase in expected U.S inflation has no effect on the euro interest rate.

The increase in the interest rate from R1$ to R2$ creates a momentary excess supply of real U.S money balances at the prevailing price level P1. Though since under this financial Approach prices are assumed to be flexible prices will immediately adjust from P1 to P2 therefore causing the following two effects that are Reducing real money supply and Bringing the U.S money market back into equilibrium.