pset12ans - Problem Set#12 1 Explain how permanent shifts...

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Problem Set #12 1. Explain how permanent shifts in national real money-demand functions affect real and nominal exchange rates in the long run. A permanent shift in the real money demand function will alter the long-run equilibrium nominal exchange rate, but not the long-run 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 long-run 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 price-level 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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This note was uploaded on 02/05/2011 for the course ECM 61 taught by Professor Jackparkinson during the Summer '10 term at University of Toronto.

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pset12ans - Problem Set#12 1 Explain how permanent shifts...

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