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.