Answer Happy

Interest rates may have to rise sharply to fight inflation “[...] In America consumer-price inflation has reached 7% and, far from being transitory, is feeding through into wages as the idea that bills will go up is being baked into households' and firms' expectations. Private-sector wages and salaries in America are up 5% in a year. In December the median American consumer expected prices to rise by 6% over 12 months. [...]” Two key questions for the European Central Bank "[...] Many of the ECB's rich-world counterparts, including the Federal Reserve and the Bank of England, are worried that inflation could become entrenched. In the euro area, however, the greater likelihood is perhaps that, once disruptions from the pandemic fade, it still undershoots the ECBS's 2% target. [...]." Task According to the abovementioned Economist excerpt what do you expect to happen with the US exchange rate relative to the Euro, assuming that the quoted inflation rates represent the expected inflation rates in the two economies? What would you recommend to the FED president to maintain a strong dollar while keeping the dollar euro exchange rate (Este) stable? Justify your recommendation with the appropriate theoretical framework. Suppose that the FED follows your recommendation, explain in your own words and illustrate graphically how nominal money supply, real money balances, nominal interest rate, price level and dollar euro exchange rate, evolve over time. Lastly, explain why or why not you expect exchange rate overshooting. (Hint: Assume that changes in the rate of money supply is equivalent to a permanent change in the level of Money Supply)