Exchange Rate Dynamics. Britain and Europe have no inflation, a constant money supply and (annualized) interest rates equal to 2% for all maturities. The exchange rate is equal to one pound per euro; this is its PPP value and the price indexes can be assumed to be equal to one in both countries.
Suddenly and unexpectedly, Britain increases its money supply by 5%. This is a one-time but permanent shock. Immediately upon the announcement, the British interest rate drops from 2% to 1% for all maturities (excess liquidity induces a drop in the real interest rate). It is expected that it will take three years for the shock in money supply to translate fully into a price increase. There is no effect on the real sector, nor any effect on Europe. Assume that the Eurozone is the domestic country. What will be the exchange rate dynamics?

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The Answer of Exchange Rate Dynamics. Britain and Europe have no inflation, a constant money supply and (annualized) interest rates equal to 2% for all maturities. The exchange rate is equal to one pound per euro; this is its PPP value and the price indexes can be assumed to be equal to one in both countries.
Suddenly and unexpectedly, Britain increases its money supply by 5%. This is a one-time but permanent shock. Immediately upon the announcement, the British interest rate drops from 2% to 1% for all maturities (excess liquidity induces a drop in the real interest rate). It is expected that it will take three years for the shock in money supply to translate fully into a price increase. There is no effect on the real sector, nor any effect on Europe. Assume that the Eurozone is the domestic country. What will be the exchange rate dynamics?