Use the money market and FX diagrams to answer the following questions about the relation- ship between the euro and US dollar. We would consider how a change in the U.S. money supply affects interest rates and exchange rates. On graphs, all variable in the initial equilib- rium is labeled using superscript 1.
(a) Suppose that US temporarily decreases US money supply. Illustrate how a temporary decrease in US money supply affects the money market and the FX market in the short- run. Label your short-run equilibrium point 2.
(b) Using your diagram from (a), state how US interest rate (i$), E$/AC, and Ee change in $/AC the short run (increase/decrease/no change).