Question

Imagine that the following events occurred between 1995 and 2020. - While New Zealand reduced its money supply by 10 percent, Japan kept its money supply constant. - Japanese real GDP increased by 10 percent, while the real GDP of New Zealand stayed constant. Seeing these as long run events, analyze the effects on nominal exchange rate, EnZS/Yen, by:

a) using the basic monetary approach (i.e. PPP based model without the real exchange rate extension),

Answer 1

When New zealand reduces its money supply, it causes an appreciation of the nominal exchange rate EnZS/Yen, while the nominal exchange rate remains constant for Japan.

Step-by-step explanation:

In this scenario, New Zealand reduced its money supply by 10 percent, while Japan kept its money supply constant. At the same time, Japanese real GDP increased by 10 percent, while the real GDP of New Zealand stayed constant. Using the basic monetary approach, the effects on the nominal exchange rate, EnZS/Yen, can be analyzed.

According to the basic monetary approach, the nominal exchange rate is determined by the relative money supplies of the two countries. When New Zealand reduces its money supply, it causes a decrease in the supply of New Zealand dollars in the foreign exchange market. This leads to an increase in the value of the New Zealand dollar relative to the Japanese yen, resulting in an appreciation of the nominal exchange rate EnZS/Yen.

On the other hand, when Japan keeps its money supply constant, it does not cause any changes in the supply of Japanese yen. Therefore, the nominal exchange rate remains constant.