1. Consider the model we studied in the lectures. Analyze the effects of the fol
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Question
1. Consider the model we studied in the lectures. Analyze the effects of the following events on () interest rate of US, (i) interest rate of EZ and (ii) S/ exchange rate. a. There is an economic boom in the US, which increases US income. b. The Fed decides to decrease the money supply c. The ECB choose to print more money. 2. Take a look at the next picture. Describe what you see and discuss whether your answer in b) and c) would change. Do you need more information? Hint: does the central bank prints money just today? Permanently? Are we looking ot the effect on the short run, long run? 1989 1988 1992 1991 987 995 1996 2003 20o6 10 1000 Percent inoase in money sucpExplanation / Answer
1. An increase in income will reduce the interest rate in US . This is because with increased income people are holding more money than required . Thus they will demand higher bonds and securities . Thus the interest rate offered will fall.
Due to low interest rate in US. there will be outflow of capital . Capital will flow into Europe where interest rate are higher This will lead to fall in interest rate in Europe till interest rate become equal in both countries.
$/€ will increase because dollar will depreciates due to outflow of capital from US and euro appreciate due to inflow of capital into Europe.
b) Due to fall in money supply interest rate in US will increase . This is because a fall in money supply will reduce vdemand for bonds. Thus increasing interest rate .
Due to higher interest rate in US . There will be capital outflow from Europe this will lead to increase in interest rate in Europe.
Exchange rate fall as dollar appreciate due to capital inflow and euro depreciates due to capital outflow.
c) Interest rate in Europe will fall because by printing more money . Money supply will increase in Europe . This will lead to increase in interest rate in US .
Interest rate in Europe will fall because people have more money than they demand . They will buy more bonds which will lead to fall in interest rate in Europe . This will lead to capital outflow from Europe .
Exchange rate increases as dollar depreciates and euro appreciate .
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