Problem Set #12
1.
Explain how permanent shifts in national real moneydemand functions affect real and
nominal exchange rates in the long run.
A permanent shift in the real money demand function will alter the longrun
equilibrium nominal exchange rate, but not the longrun equilibrium real exchange
rate. Since the real exchange rate does not change, we can use the monetary
approach equation,
E
= (
M
/
M
*
) × {
L
(
R
*
,
Y
*
)/
L
(
R
,
Y
)}. A permanent increase in
money demand at any nominal interest rate leads to a proportional appreciation of
the longrun nominal exchange rate. Intuitively, the level of prices for any level of
nominal balances must be lower in the long run for money market equilibrium. The
reverse holds for a permanent decrease in money demand. The real exchange rate,
however, depends upon relative prices and productivity terms which are not
affected by general pricelevel changes.
2.
Explain how the nominal dollar/euro exchange rate would be affected (all else equal) by
permanent changes in the expected rate of real depreciation of the dollar against the euro.
A permanent increase in the expected rate of real depreciation of the dollar against
the euro leads to a permanent increase in the expected rate of depreciation of the
nominal dollar/euro exchange rate, given the differential in expected inflation rates
across the U.S. and Europe. This increase in the expected depreciation of the dollar
causes the spot rate today to depreciate.
3.
In the short run of a model with sticky prices, a reduction in the money supply raises the
nominal interest rate and appreciates the currency. What happens to the expected real
interest rate? Explain why the subsequent path of the real exchange rate satisfies the real
interest parity condition.
The initial effect of a reduction in the money supply in a model with sticky prices is
an increase in the nominal interest rate and an appreciation of the nominal
exchange rate. The real interest rate, which equals the nominal interest rate minus
expected inflation, rises by more than the nominal interest rate since the reduction
in the money supply causes the nominal interest rate to rise, and deflation occurs
during the transition to the new equilibrium. The real exchange rate depreciates
during the transition to the new equilibrium (where its value is the same as in the
original state). This satisfies the real interest parity relationship which states that
the difference between the domestic and the foreign real interest rate equals the
expected depreciation of the domestic real exchange rate—in this case, the initial
effect is an increase in the real interest rate in the domestic economy coupled with
an expected depreciation of the domestic real exchange rate. In any event, the real
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 Summer '10
 JackParkinson
 Exchange Rate, Inflation, Foreign exchange market, real exchange rate

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