Please draw the graphs of interest rates(iUS) and exchange rates(E$/¥).
(a) US and Japanese interest rates are both equal to 0.25% a year and E$/¥ = 0.01. Assume foreign exchange and domestic money markets are initially in equilibrium. The Federal Reserve announces an unexpected temporary contraction of the US money supply: for the next three months the money supply will be 2% lower, before returning to its initial level in three months. Graph the response of US interest rates and the $-¥ exchange rate over the next three months, assuming that Japanese monetary policy does not change in response to the Fed’s announcement and that investors believe the Fed’s commitment to increase the money supply in the future.
(b) At the end of the three month period, the Fed announces that in fact it will not reverse its reduction of the money supply, which will be permanently 2% lower. Repeat your graph from part (a), extending it forward in time to show the expected response of US interest rates and the exchange rate over the year following the second announcement, assuming again that there is no change in Japanese policy and the Fed is expected to abide by this new policy.