Explain effects of change in u.s. expected inflation, International Economics

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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.

 

323_U.S. expected inflation.png

 

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.


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