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Unformatted text preview: Econ315: International Macroeconomics Solution problem set 4 Note: this problem set will not be graded. In the second part of the course problem sets will be graded every other time . Exercise 1 a) By the Cambridge quantity equation we can write: M d = kPy where M d is the demand for money in the economy, k a positive constant, P the price level and Y the real output; We have a corresponding equation for the foreign country (*): M d = k P y We assume that the money supply is xed at M s i , and that the equilibrium condition in the money market is M s = M d for each country. This equilibrium condition gives us the domestic and for- eign price level as a function of M s and output. We thus have P = M s ky ; P = M s k y PPP implies that the nominal exchange rate e is such that P = eP By simple substitution we have e = P P = M s M s k k y y The nominal exchange rate is thus determined (in the long run) by relative changes in money supplies, in real national income (due to demographic changes, capital accumulation or technological progress) and by changes in the relative circulation of money inside the economies. 1 b) We can compute how the nominal exchange rate reacts to changes in the exogenous variables in the two countries by looking at the expression we derived above. We can write E 1 E = M s M s k k y 1 y 1 y y = M s M s k k y 1 y y 1 y y 1 y = M s M s k k y 1 y y y y 1 y + y y y 1 y = M s M s k k ( y 1...
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- Spring '11