A country has had a steady value for its floating exchange rate (stated inversely as the domestic currency price of foreign currency) for a number of years. The country now tightens up on (reduces) its money supply dramatically. The country’s product price level is not immediately affected, but the price level gradually becomes lower (relative to what it otherwise would have been) during the next several years.
a. Why might the market exchange rate change a lot as this monetary tightening is announced and implemented?
b. What is the path of the market exchange rate likely to be over the next several years? Why?