Econ 122_Burstein_2013 Midterm.pdf

# B an appreciation of the us real exchange rate c an

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(b) an appreciation of the US real exchange rate. (c) an increase in the rate of depreciation of the dollar nominal exchange rate (d) a decline in the rate of depreciation of the dollar nominal exchange rate. Answers 5

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1. C 2. E 3. B 4. D 5. A 6. C 7. B 8. C 9. C 10. E 11. E 12. A 13. D 14. C 15. A 16. C 17. D Part II: Longer questions For questions 1 and 2, we assume that the economy is described by (1) : Money Market Clearing: M P = L ( R, Y ) and (2) : Uncovered Interest Parity: 1 + R = ! 1 + R f " E e E , or the approximated version (you can use any of the two) (2) : Uncovered Interest Parity: R = R f + E e E E . The real exchange rate is defined as q = E P f /P . Here L (‘money demand’) is decreasing in the interest rate R and increasing in the level of output Y. We will assume that Y and P f remain constant over time. The variable R f denotes 6
the foreign interest rate. The nominal exchange rate E is quoted as domestic currency per foreign currency. E e denotes the expected exchange rate in the long run. We also assume that P is sticky in the short run, and prices are flexible in the long run. The real exchange rate may vary in the short run when prices are sticky, but remains constant in the long run unless otherwise indicated (see e.g. Question 2). The economy starts in a long run equilibrium with M s , P , E and E e constant. Question 1: Exchange rates and monetary policy (18 points) Consider an economy characterized by a demand for money of the form L ( Y, R ) = 2 Y 3 R We assume that Y = 1 throughout the exercise. The supply of money ! M S " is controlled by the Central Bank. Assume that M s has been constant for many periods and that initially the economy is in equilibrium with P , E and E e constant. In particular, suppose that the initial level of M s is equal to 10 and the initial level of the nominal exchange rate is equal to E = 1 . Suppose also that the foreign interest is initially 8% ( R f = 0 . 08 ). 1. Solve for the initial level of the price level, P (4 points). In the initial equilibrium, we have E = E e , so from UIP, R = R f = 0 . 08 . The level of P that clears the money market is P 0 such that 10 P 0 = 2 3 0 . 08 or P 0 = 10 1 . 76 = 5 . 68 . 2. Suppose that there is a temporary decline in the foreign interest rate R f , from 0 . 08 to 0 . 05 . Solve for the domestic interest rate R and the exchange-rate in the short-run equilibrium if M s remains constant (4 points). With M s fixed, P sticky and Y unchanged, the market clearing domestic interest must be the same as in the initial equilibrium. That is, R = 0 . 08 . Given that this is a temporary shock, the expected exchange rate remains at E e = E 0 = 1 . We use UIP to solve for the spot exchange rate in the short run: 1 + 0 . 08 = (1 + 0 . 05) E e E or with E e = 1 , E = 1 . 05 1 . 08 = 0 . 97 or using the approximated version of UIP, 0 . 08 = 0 . 05 + 1 E E 7

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so E = 1 0 . 08 0 . 05 + 1 = 0 . 971 Therefore, the domestic currency appreciates.
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