# C suppose the bank of korea increases the money

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c. Suppose the Bank of Korea increases the money growth rate from 12% to 15%. If nothing in Japan changes, what is the new inflation rate in Korea? Answer: new K K g K 15% 6% 9% S-16 Solutions Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run

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Solutions Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run S-17 d. Using time series diagrams, illustrate how this increase in the money growth rate affects the money supply, M K ; Korea’s interest rate; prices, P K ; real money supply; and E won over time. (Plot each variable on the vertical axis and time on the hor- izontal axis.) Answer: See the following diagrams. M K 1 2 P K T Time 1 2 Time M K / P K E won/Y Time Time K2 J K1 J Bank of Korea increases money growth rate g M K 1 2 7% 2 1 P K T Time 1 Time M K / P K E won/Y Note that E actually falls here because the won appreciates Time Time K2 J 0 K1 J Bank of Korea reduces the money growth rate to less than 7% g
e. Suppose the Bank of Korea wants to maintain an exchange rate peg with the Japanese yen. What money growth rate would the Bank of Korea have to choose to keep the value of the won fixed relative to the yen? Answer: To keep the exchange rate constant, the Bank of Korea must lower its money growth rate. We can figure out exactly which money growth rate will keep the exchange rate fixed by using the fundamental equation for the simple monetary model (used above in [b]): % E e won ( K g K ) ( J g J ) The objective is to set % E e won 0: ( * K g K ) ( J g J ) Plug in the values given in the question and solve for * K : ( * K 6%) (2% . 1%) * K 7% Therefore, if the Bank of Korea sets its money growth rate to 7%, its exchange rate with Japan will remain unchanged. f. Suppose the Bank of Korea sought to implement policy that would cause the Korean won to appreciate relative to the Japanese yen. What ranges of the money growth rate (assuming positive values) would allow the Bank of Korea to achieve this objective? Answer: Using the same reasoning as previously, the objective is for the won to appreciate: % E e won 0 This can be achieved if the Bank of Korea allows the money supply to grow by less than 7% each year. The diagrams on the following page show how this would affect the variables in the model over time. 8. This question uses the general monetary model, in which L is no longer assumed constant and money demand is inversely related to the nominal interest rate. Con- sider the same scenario described in the beginning of the previous question. In addi- tion, the bank deposits in Japan pay 3% interest; i ¥ 3%. a. Compute the interest rate paid on Korean deposits. Answer: Fisher effect: ( i won i ¥ ) ( K J ) Solve for i won (6% 1%) 3% 8% b. Using the definition of the real interest rate (nominal interest rate adjusted for inflation), show that the real interest rate in Korea is equal to the real interest rate in Japan. (Note that the inflation rates you calculated in the previous question will apply here.) Answer: r ¥ i ¥ J 2% 1% 1% r won i won K 8% 6% 2% c. Suppose the Bank of Korea increases the money growth rate from 12% to 15% and the inflation rate rises proportionately (one for one) with this increase. If the

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