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Unformatted text preview: Econ315: International Macroeconomics Solution problem set 8 Note: this problem set will not be graded. In the second part of the course problem sets will be graded every other time . STRUCTURE OF THE MODEL: Consider the following small open economy model. The money demand equation is decreasing in the nominal interest rate: M d t P t = i t (1) and money supply follows from Central Bank balance sheet: M s t = FX t + DC t (2) The money market equilibrium implies: FX t + DC t P t = i t (3) Under perfect capital mobility the uncovered interest rate parity equation holds: e e t +1 e t e t = i t i t (4) We assume that there is perfect foresight so that the agents correctly foresee the future path of the nominal exchange rate. We normalize the foreign interest rate to 0. e e t +1 = e t +1 with i t = 0 ) e t +1 e t e t = i t In this simple model we also assume that purchasing power parity holds and we normalise the foreign price level to 1. e t P t P t = 1 with P t = 1 ) e t = P t a) The domestic credit component of the money supply expands constantly at the rate : DC t = DC t 1 + In order to keep the exchange rate xed the central bank needs to maintain the overall money supply constant. If the nominal exchange rate is xed at 1 the level e; we have from (4) that the nominal interest rate is equal to the foreign correspondent and equal to zero. Since purchasing power parity holds, the money market equilibrium (3) implies that...
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- Spring '11