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Unformatted text preview: Problem Set 2: Solutions 1. Consider the model of short run exchange rate determination in Lec- ture 2 or K-O Ch. 13-14. The model relates equilibrium in the money market to equilibrium in the foreign exchange market. An increase in domestic real GNP will increase the demand for money. This shifts the money demand curve Md P downwards in the lower panel of the dia- gram. Interest rates will be bid up. Since the uncovered interest parity con- dition (UIRP) i $ = i $ + e e e e is assumed to hold, if foreign interest rates and expectations of future exchange rates are unchanged, then there must be an appreciation of domestic currency, shown by a decrease in e from E to E 1 . Intuitively, higher domestic interest rates will encourage investors to invest do- mestically. This greater demand will bid up the value of the domestic currency, causing it to appreciate. If, on the other hand, foreign real GNP increases, we know that this will raise interest rates in foreign, so from UIRP i $ = i $ + e e e e with constant current and expected exchange rates, the domestic rate of return on a foreign asset must increase. This shifts the foreign return curve i $ + e e e e outwards. As a result, the domestic currency depreciates; e rises from E to E 1 . Intuitively, because foreign interest rates are higher, ceteris paribus, investors will demand foreign assets. This will lead to a fall in the value of the domestic currency, i.e. a depreciation. [See gures 1 and 2 for the relevant diagrams]. 2. Consider the two period small open economy model of the lecture notes. The representative household's preferences are given by: U = ln C 1 + ln C 2 (1) a) In equilibrium it must be that B 3 =0 because the world ends at the end of period 2 (B 3 is the stock of assets at the end of period 2). Any loans outstanding at the end of period 2 cannot be repaid. No lender would lend under such conditions....
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- Spring '11
- Exchange Rate