Relationship b/w u.s. real money supply and dollar exchange, International Economics

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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.

1435_U.S. real money supply and the dollar-euro exchange rate.png

 

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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