Problem
Use the money market and FX diagrams to answer the following questions regarding Home and Foreign country. Assume the Home country decreases the money supply.
1. Assume the change in Home money supply is temporary. Show and explain how equilibrium changes.
2. Assume the change in Home money supply is permanent. Show and explain how equilibrium changes. Explain the transition from the Short Run to the Long Run.
3. Illustrate how each of the following variables changes over time in response to a permanent decrease in the money supply: nominal money supply MH, price level pH, real money supply MH/PH, Home interest rate iH, and the exchange rate EF/F.
4. Does overshooting happen in the case of a permanent decrease in the Home money supply? Explain.