G2_ans_au15 - products has to occur This price change is a...

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Econ171 Dongwon Lee 1 Econ171 International Finance Group Exercise #2 Answers 1. Productivity growth has increased in Central and Eastern European countries relative to Western European countries. What happens to the Czech real exchange rate if the Czech Republic has a one-time increase in productivity relative to that of France? What happens to its nominal exchange rate? (Hint: The effect of a change in productivity is analogous to the discussion in Ch.16 on the effect of a change in relative output supply on exchange rates.) The increase in relative productivity of the Czech economy means more output being produced in the Czech Republic. However, because output and, hence, income in France do not change, the demand by foreigners for domestic goods in Czech is still the same. This means that there will be an excess relative supply for Czech output at the previous real exchange rates. To eliminate this excess supply, a decrease in the price of Czech products relative to French products has to occur. This price change is a real depreciation of the Czech Republic currency (koruna).
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Unformatted text preview: products has to occur. This price change is a real depreciation of the Czech Republic currency (koruna). To learn what happens to the price level, we also have to think about the impact of an increase in Czech productivity on the aggregate real money demand. As output in the Czech Republic rises due to the increase in productivity, aggregate real money demand also rises, as people have more goods and services to buy with their money (i.e., transaction demand rises). This pushes the price level down in order to make the supply of real money balances increase and equilibrate the money market (the relevant equilibrium equation here is: g G± ↓ = ² G± ³ /L(´ µ¶·¸¹º ,» G± ↑) Because the price level in the Czech Republic falls and the real exchange rate depreciates, the net effect on nominal exchange rates is ambiguous: ¼ µ¶·¸¹º /€ ½¾¿¾À ? = Á G± /± ½¿À ↑ × g G± à ↓ / g ±...
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