Q. Using figures for both the short run and the long run, show the effects of a permanent increase in the U.S. money supply. Try to line up your figures to the short and long run equilibria side by side. Assume that the U.S. real national income is constant.

Answer:

An increase in the supposed money supply raises the real money supply and lowering the interest rate in the short run the movement from 1 to 2 on the lower left figure. The money supply raise is considered to continue in the future and therefore it will affect the exchange rate expectations. This will compose the expected return on the euro more desirable and therefore the dollar depreciates. In the case of an enduring increase in the U.S. money supply and the dollar depreciates more than under a temporary increase in the money supply from point 1' to point 2' in the upper left figure.

In the long run the right hand side figure prices will increase until the real money balances are the same as prior to the permanent increase in the money supply from point 2 to point 4 in the lower right figure. Ever since the output level is given the U.S. interest rate which reduce before will start to increase until it will move back to its original level from Point 2 to 4 in the lower left figure. The balance interest rate should be the same as its original long-run value at point 4 in the lower right figure.

These increases in the interest rate have to cause the dollar to appreciate against the euro after its sharp depreciation as a result of the enduring increase in the money supply this process is depicted in the upper right figure from point 2' to 4'. Consequently a large depreciation from point 1' in the left upper figure to pint 2' in both the left and right upper figures is followed by an appreciation of the dollar the movement from 2' to point 4' in the upper right hand side figure. Ultimately the dollar depreciates in proportion to the increase in the price level which in turn increases by the similar proportion as the permanent increase in the money supply. Therefore the money is neutral in the sense that it can't affect in the long-run real variables for instance investment, output, and so on. Note that points 3' and 4' correspond to the same exchange rate.