Question: Use the money market and FX diagrams to answer the following questions about the relationship between the British pound (£) and the U.S. dollar ($). The exchange rate is in U.S. dollars per British pound E$/£. We want to consider how a change in the U.S. money supply affects interest rates and exchange rates. On all graphs, label the initial equilibrium point A.
a. Illustrate how a temporary decrease in the U.S. money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
b. Using your diagram from (a), state how each of the following variables changes in the short run (increase/decrease/no change): U.S. interest rate, British interest rate, E$/£, Ee$/£, and the U.S. price level P.
c. Using your diagram from (a), state how each of the following variables changes in the long run (increase/decrease/no change relative to their initial values at point A): U.S. interest rate, British interest rate, E$/£, Ee$/£, and U.S. price level P.