2. Suppose money demand can be described as M/P = 120 – 400i, where i is the nom

Question

2. Suppose money demand can be described as M/P = 120 – 400i, where i is the nominal interest rate. Assume that the expected future exchange rate equals 2 and that the foreign interest rate equals .05.

a. Suppose the price level equals one and the nominal money supply equals 100. Calculate the nominal interest rate.

b. Calculate the spot exchange rate according to uncovered interest rate parity

c. Suppose there is a temporary increase in the nominal money supply to 110. Assume that the price level remains at one. Calculate the new nominal interest rate.

d. Calculate the new spot exchange rate. (Hint: use the same procedure as part b). Now assume that the increase in the money supply in part c was permanent, not temporary. The foreign country interest rate has not changed.

e. What will be the value of the price level in the long run? (Hint: assume the quantity theory of money).

f. What will be the value of the exchange rate in the long run? (Hint: use your answer in part e and PPP).

g. Calculate the value of the exchange rate immediately after the increase in the money supply. (Hint: remember exchange rate overshooting). h. Suppose after one-year the price level has increased from 1 to 1.02. What will be the value of the interest rate? (Hint: use the money supply-money demand equation from the beginning of the problem.)

Explanation / Answer

M/P = 120 - 400i

(a) M = 100, P = 1

100 / 1 = 120 - 400i

100 = 120 - 400i

400i = 20

i = 20 / 400 = 0.05 (5%)

(b)

Expected Future rate (F) = Spot rate (S) x (1 + Domestic interest rate) / (1 + Foreign interest rate)

2 = S x (1.05) / (1.05)

S = 2

(c) M = 110, P = 1

110 / 1 = 120 - 400i

110 = 120 - 400i

400i = 10

i = 10 / 400 = 0.025 (2.5%)

(d)

Now,

2 = S x (1.025) / (1.05)

2 = S x 0.9762

S = 2.0488

NOTE: First 4 sub-questions are answered.

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