Intermediate Macroeconomics 161B
Intermediate Macroeconomics 161B Amjad Toukan Spring 2024 PROBLEM SET 2 Due on April 27th, 2024 1) Describe how each of the following factors might explain why PPP is a better guide for exchange rate movements in the long run versus the short run: (i) transactions costs, (ii) nontraded goods, (iii) imperfect competition, (iv) price stickiness. As markets become increasingly integrated, do you suspect PPP will become a more useful guide in the future? Why or why not? 2) Consider two countries: Japan and South Korea. In 1996 Japan experienced relatively slow output growth (1%), whereas South Korea had relatively robust output growth (6%). Suppose the Bank of Japan allowed the money supply to grow by 2% each year, while the Bank of Korea chose to maintain relatively high money growth of 15% per year. In addition, the bank deposits in Japan pay a 3% interest rate, i¥ = 3% . This question uses the general monetary model, where L is no longer assumed constant and money demand is inversely related to the nominal interest rate. You will find it easiest to treat South Korea as the home country and Japan as the foreign country. a. Compute the interest rate paid on South Korean won deposits. b. Using the definition of the real interest rate (nominal interest rate adjusted for inflation), show that the real interest rate in South Korea is equal to the real interest rate in Japan. c. Suppose the Bank of Korea decreases the money growth rate from 15% to 12% and the inflation rate falls proportionately (one for one) with this increase. If the nominal interest rate in Japan remains unchanged, what happens to the interest rate paid on Korean won deposits? d. Using time series diagrams, illustrate how this decrease in the money growth rate affects the money supply M K ; South Korea’s interest rate; prices PK ; real money supply; and Ewon/ ¥ over time. (Plot each variable on the vertical axis and time on the horizontal axis.) 3) Use the money market and FX diagrams to answer the following questions. This question considers the relationship between the Indian rupees (Rs) and the U.S. dollar ($). The exchange rate is in rupees per dollar, ERs/$ . On all graphs, label the initial equilibrium point A. a. Illustrate how a permanent decrease in India’s money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C. b. By plotting them on a chart with time on the horizontal axis, illustrate how each of the following variables changes over time (for India): nominal money supply M IN , price level PIN , real money supply M IN /PIN , India’s interest rate iRs , and the exchange rate ERs/$ . c. Using your previous analysis, state how each of the following variables changes in the short run (increase/decrease/no change): India’s interest rate iRs , the exchange rate ERs/$ , expected exchange rate E e Rs/$ , and price level PIN . d. Using your previous analysis, state how each of the following variables changes in the long run (increase/decrease/no change relative to their initial values at point A): India’s interest rate iRs , the exchange rate ERs/$ , the expected exchange rate E e Rs/$ , and India’s price level PIN . e. Explain how overshooting applies to this situation. 4) Use the money market and FX diagrams to answer the following questions. This question considers the relationship between the euro (€) and the U.S. dollar ($). The exchange rate is in U.S. dollars per euro, E$/ € . Suppose that with financial innovation in the United States, real money demand in the United States decreases. On all graphs, label the initial equilibrium point A. a. Assume this change in U.S. real money demand is temporary. Using the FX/money market diagrams, illustrate how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C. b. Assume this change in U.S. real money demand is permanent. Using a new diagram, illustrate how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C. c. Illustrate how each of the following variables changes over time in response to a permanent reduction in real money demand: nominal money supply M US , price level PUS , real money supply M US /PUS , U.S. interest rate i$ , and the exchange rate E$/ € . 5) This question considers how the FX market will respond to changes in monetary policy in South Korea. For these questions, define the exchange rate as South Korean won per Japanese yen, Ewon/ ¥ . Use the FX and money market diagrams to answer the following questions. On all graphs, label the initial equilibrium point A. a. Suppose the Bank of Korea permanently increases its money supply. Illustrate the shortrun (label equilibrium point B) and long-run effects (label equilibrium point C) of this policy. b. Now, suppose the Bank of Korea announces it plans to permanently increase its money supply but doesn’t actually implement this policy. How will this affect the FX market in the short run if investors believe the Bank of Korea’s announcement? c. Finally, suppose the Bank of Korea permanently increases its money supply, but this change is not anticipated. When the Bank of Korea implements this policy, how will this affect the FX market in the short run? d. Using your previous answers, evaluate the following statements: • If a country wants to decrease the value of its currency, it can do so (temporarily) without raising domestic interest rates. • The central bank can increase both the domestic price level and the value of its currency in the long run. • The most effective way to decrease the value of a currency is through surprising investors.
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