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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$/E is equal to the price level ratio PUS/ PE in this derivation of the relationship the following variables are assumed constants,
M1US, RE, and PE
So, E$/E = M1US/PUS
The raise in PUS leads to a positive increase in E$/E.
P1US will shift to P2US
Therefore the purchasing power of the dollar decreases because of the increase in the price level.
E1$/E will shift to E2$/E
Explicitly the dollar depreciates due to PPP.
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