To answer the following question, please refer to the figure below. Co

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.

What will be an ideal response?

ANSWER

Lower right quadrant shows the equilibrium in the U.S. Money Market, where
= /
A given interest rate R1$ corresponds with a given U.S. real money supply, / .
Consider a rise of ΔΠ in the future rate of U.S. money supply growth (i.e. an increase in the expected rate of inflation).
The Key Point: The rise in expected future inflation generates expectations of more rapid currency depreciation in the future.
Under PPP the dollar now depreciates at a rate of Π + ΔΠ. Interest parity therefore requires the dollar interest rate to rise where
= + ΔΠ. (Point 2 in the figure.)
Note: R$ – = –
This relation shows a change in the U.S. interest rate due to an increase in expected U.S. inflation has no effect on the euro interest rate.

The rise in the interest rate from to creates a momentary excess supply of real U.S. money balances at the prevailing price level . However, since under this.
Monetary Approach, prices are assumed to be flexible, prices will immediately adjust from to , thus causing the following two effects: One, Reducing real money supply and two, bringing U.S. money market back into equilibrium.