Answer to Question #227736 in Macroeconomics for mandy

Question

use illustrative diagrams to explain the effects of a monetary contraction on output, composition of output, interest rate, and on the exchange rate under the flexible exchange rate system

Answer 1

Effect of Monetary contraction on exchange rate: 

where D= demand for foreign currency

      D'= decreased demand due to contraction

      S = Supply of foreign currency

     FER = foreign exchange rate before contraction

     FER' = foreign exchange rate after contraction

      Q = quantity of foreign exchange before contraction

      Q' = quantity of foreign exchange after contraction

Effect of Monetary contraction on output and the rate of interest: 

Due to the contractionary monetary policy the LM curve shifts leftwards to LM' due to which the rate of interest will increase and the output level will decrease. This would increase the foreign capital inflow due to the flexible exchange rate and the currency will appreciate. This appreciation is associated with a leftward shift of the IS curve and it shifts leftwards to IS' and the new equilibrium is obtained at E' implying no change in the rate of interest but a fall in the level of output.