HW2_solution

# HW2_solution - Econ 457, Fall 2010 Problem Set II:...

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Econ 457, Fall 2010 Problem Set II: solutions Problems from the textbook: Chapter 14: 4, 5, 10 4. An increase in domestic real GNP increases the demand for money at any nominal interest rate. This is reflected in Figure 14.2 as an outward shift in the money demand function from L 1 to L 2 . The effect of this is to raise domestic interest rates from R 1 to R 2 and to cause an appreciation of the domestic currency from E 1 to E 2 .

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5. Just as money simplifies economic calculations within a country, use of a vehicle currency for international transactions reduces calculation costs. More importantly, the more currencies used in trade, the closer the trade becomes to barter, since someone who receives payment in a currency she does not need must then sell it for a currency she needs. This process is much less costly when there is a ready market in which any nonvehicle currency can be traded against the vehicle currency, which then fulfills the role of a generally accepted medium of exchange. 10. If an increase in the money supply raises real output in the short run, then the fall in the interest rate will be reduced by an outward shift of the money demand curve caused by the temporarily higher transactions demand for money. In Figure 14.3, the increase in the money supply line from ( M 1 / P ) to ( M 2 / P ) is coupled with a shift out in the money demand schedule from L 1 to L 2 . The interest rate falls from its initial value of R 1 to R 2 , rather than to the lower level R 3 , because of the increase in output and the resulting outward shift in the money demand schedule. Because the interest rate does not fall as much when output rises, the exchange rate depreciates by less: from its initial value of E 1 to E 2 , rather than to E 3 , in the diagram. In both cases we see the exchange rate appreciate back some to E 4 in the long run. The difference is the overshoot is much smaller if there is a temporary increase in Y . Note, the fact that the increase in Y is temporary means that we still move to the same IP curve, as LR prices will still shift the same amount when Y returns to normal, and we still have the same size M increase in both cases. A permanent increase in Y would involve a smaller expected price increase and a smaller shift in the IP curve. Chapter 15 1, 3, 6, 9, 12, 18, 19 1. Relative PPP predicts that inflation differentials are matched by changes in the exchange rate. Under relative PPP, the franc/ruble exchange rate would fall by 95 percent with inflation rates of 100% in Russia and 5% in Switzerland. 3.a. A tilt of spending towards nontraded products causes the real exchange rate to appreciate as the price of nontraded goods relative to traded goods rises (the real exchange rate can be expressed as the price of tradables to the price of nontradables).
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## This note was uploaded on 08/01/2011 for the course ECON 457 taught by Professor Staff during the Spring '11 term at Iowa State.

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HW2_solution - Econ 457, Fall 2010 Problem Set II:...

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