Suppose that inflation rates are initially zero in the euro area and the US, nominal interest rates in the two economies are initially equal, and the price level is constant in the short run and flexible in the long run. Today, the ECB adopts the digital euro, leading to a permanent decline in the demand for real money balances in the euro area, while the ECB keeps the level of its nominal money supply unchanged. The US Federal Reserve maintains its current monetary and payment system.Use the complete theory of the FX determination to answer the following questions, treating the euro area as the Home country.to analyse the short-run and the long-run effects of adopting the digital euro on the nominal interest rate, the price level and real money balances in the euro area, respectively. Explain your findings intuitively. [6 marks][Hints: page 10 of lecture 4A shows that a rise in real income increases the demand for real money balances, leading to a rise in the nominal interest rate in the short run. In our current question, adopting the digital euro permanently decreases the demand for real money balances in the euro area, while the level of nominal money supply stays unchanged. How does the nominal interest rate in the euro area respond in the short run? In the long run, how will the price level change so that the nominal interest rate in the euro area gradually returns to its initial level?](b). Use the diagram of the FX market equilibrium (i.e., the UIP) to analyse how the nominal exchange rate E€/$ changes in the short run and in the long run, respectively. Does the exchange rate overshooting occur? Explain your findings intuitively. [4 marks] [Hint: Identify the base currency and stick with your choice in the entire analysis](c). If the ECB intends to avoid exchange rate movements, how should it change the level of its nominal money supply when adopting the digital euro? Explain your findings intuitively. [word limit: 80] [3 marks]
Question
Suppose that inflation rates are initially zero in the euro area and the US, nominal interest rates in the two economies are initially equal, and the price level is constant in the short run and flexible in the long run. Today, the ECB adopts the digital euro, leading to a permanent decline in the demand for real money balances in the euro area, while the ECB keeps the level of its nominal money supply unchanged. The US Federal Reserve maintains its current monetary and payment system.Use the complete theory of the FX determination to answer the following questions, treating the euro area as the Home country.to analyse the short-run and the long-run effects of adopting the digital euro on the nominal interest rate, the price level and real money balances in the euro area, respectively. Explain your findings intuitively. [6 marks]Hints: page 10 of lecture 4A shows that a rise in real income increases the demand for real money balances, leading to a rise in the nominal interest rate in the short run. In our current question, adopting the digital euro permanently decreases the demand for real money balances in the euro area, while the level of nominal money supply stays unchanged. How does the nominal interest rate in the euro area respond in the short run? In the long run, how will the price level change so that the nominal interest rate in the euro area gradually returns to its initial level?. Use the diagram of the FX market equilibrium (i.e., the UIP) to analyse how the nominal exchange rate E€/$ changes in the short run and in the long run, respectively. Does the exchange rate overshooting occur? Explain your findings intuitively. [4 marks] Hint: Identify the base currency and stick with your choice in the entire analysis. If the ECB intends to avoid exchange rate movements, how should it change the level of its nominal money supply when adopting the digital euro? Explain your findings intuitively. [word limit: 80] [3 marks]
Solution
(a). In the short run, the adoption of the digital euro leads to a decrease in the demand for real money balances. With the supply of money remaining constant, this decrease in demand will lead to a decrease in the nominal interest rate in the euro area. Intuitively, this is because there is less demand for money, so the 'price' of money (the interest rate) falls. In the long run, the price level will adjust downwards to increase the real money supply, bringing the nominal interest rate back to its initial level. This is because with lower prices, the purchasing power of a given amount of money increases, effectively increasing the real money supply.
(b). In the short run, the decrease in the nominal interest rate in the euro area relative to the US (where rates remain constant) will lead to a depreciation of the euro against the dollar (E€/$ increases). This is because lower interest rates in the euro area make euro-denominated assets less attractive, leading investors to sell euros and buy dollars. In the long run, as the price level in the euro area adjusts downwards and the nominal interest rate returns to its initial level, the euro will appreciate back to its initial level against the dollar. This could result in exchange rate overshooting, where the initial depreciation of the euro is larger than its eventual long-run depreciation.
(c). If the ECB wants to avoid exchange rate movements, it should increase the supply of money when adopting the digital euro. This would offset the decrease in demand for money, keeping the nominal interest rate (and therefore the exchange rate) stable. Intuitively, by increasing the supply of money, the ECB is 'meeting' the lower demand for money, preventing a decrease in the 'price' of money (the interest rate).
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