The following diagram shows relationships between exchange rate E and interest rate R (first quadrant, top right); between price level P and exchange rate E (second quadrant; top left); between real money M/P and price level P (third quadrant, bottom left); and between interest rate R and real money M/P (fourth quadrant, bottom right). A. Copy the diagram. Then illustrate and explain in the diagram how an interest rate increase in the money market and foreign exchange market model affects the exchange rate in the short run. (Indicate, if one or more quadrants are not required for explaining the mechanisms.) B. What could be the reason for an interest rate increase in the money market and foreign exchange market model? Explain in the diagram used for part a of the question. C. Assume now the interest rate increase was actually caused by the reason you mentioned in part b of the question. Explain its effect in the long run? You may use the diagram from part a or draw a new diagram if that makes it clearer (but make sure the link between short and long-run remains clear).
The following diagram shows relationships between exchange rate E and interest rate R (first quadrant, top right); between price level P and exchange rate E (second quadrant; top left); between real money M/P and price level P (third quadrant, bottom left); and between interest rate R and real money M/P (fourth quadrant, bottom right).
A. Copy the diagram. Then illustrate and explain in the diagram how an interest rate increase in the
B. What could be the reason for an interest rate increase in the money market and foreign exchange market model? Explain in the diagram used for part a of the question.
C. Assume now the interest rate increase was actually caused by the reason you mentioned in part b of the question. Explain its effect in the long run? You may use the diagram from part a or draw a new diagram if that makes it clearer (but make sure the link between short and long-run remains clear).
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