Money Market and Exchange Rate

(1) Explain how the money markets of two countries are linked though the foreign exchange market.

(2) The following Figure shows the effect on the Dollar/Euro exchange rate and the Dollar interest rate after an increase in the U.S. money supply. Please explain why the dollar depreciates against the euro in this case.

 

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Dollar/euro exchange rate, Ese Este 0 Mus Pus Mus Pus U.S. real money holdings W R² 2 Dollar return R Expected euro return L(Rs. Yus) ↓ (a) Short-run effects Este Esie Eğle Rates of return (in dollar terms) Mus Půs Mus Pus N FR Dollar return Expected euro return L(Rg. Yus) U.S. real money supply U.S. real money holdings (b) Adjustment to long-run equilibrium Dollar/euro exchange rate, Ese Este 0 Mus Pus Mus Pus U.S. real money holdings W R² 2 Dollar return R Expected euro return L(Rs. Yus) ↓ (a) Short-run effects Este Esie Eğle Rates of return (in dollar terms) Mus Půs Mus Pus N FR Dollar return Expected euro return L(Rg. Yus) U.S. real money supply U.S. real money holdings (b) Adjustment to long-run equilibrium