INTERNATIONAL FINANCE
ANSWERS TO ASSIGNMENT #3 FROM CHAPTER 14
1. Question #1 from Page 366: Suppo there is a reduction in aggregate real money demand, that is, a negative shift in the aggregate real money demand function. Trace the short-run and long-run effects on the exchange rate, interest rate, and price level.
Answer:
A reduction in real money demand has the same effects as an increa in the nominal money supply. In figure 14.1, the reduction in money demand is depicted as a backward shift in the money demand schedule from L1 to L2. The immediate effect of this is a depreciation of the exchange rate from E1 to E2, if the reduction in money demand is temporary, or a depreciation to Ecad证3家乡的风俗包饺子 if the reduction is permanent. The larger impact effect of a permanent reduction in money demand aris becau this change also affects the future exchange rate expected in the foreign exchange market. In the long run, the price level ri
s to bring the real money supply into line with real money demand, leaving all relative prices, output, and the nominal interest rate the same and depreciating the domestic currency in proportion to the fall in real money demand. The long-run level of real balances is (M/P2), a level where the interest rate in the long-run equals its initial value. The dynamics of adjustment to a permanent reduction in money demand are from the initial point 1 in the diagram, where the exchange rate is E1, immediately to point 2, where the exchange rate is E3 and then, as the price level falls over time, to the new long-run position at point 3, with an exchange rate of E4花洒水流小怎么办.
Figure 14.1
2. Question #4 from Page 366: What is the short-run effect on the exchange rate of an increa in domestic real GNP, given expectations about future exchange rates?
Answer:
An increa in domestic real GNP increas the demand for money at any nominal interest rate. This is reflected in figure 14.2 as an outward shift in the money demand function from L1 to L2. The effect of this is to rai domestic interest rates from R1 to R刘琼芳2 and to cau an appreciation of the domestic currency from E1 to E2.
Figure 14.2
Figure 14.3
3. Question #10 from Page 367: In the discussion of short-run exchange rate overshooting, we assumed that real output was given (fixed). Assume instead that an incr
ea in the money supply rais real output in the short run. How does this affect the extent to which the exchange rate overshoots when the money supply first increas? Is it likely that the exchange rate undershoots? (Hint: in Figure 14-12a of the book – the money demand – money supply diagram, allow the aggregate real money demand schedule to shift in respon to the increa in output.)磁流变阻尼器
Answer:
If an increa in the money supply rais real output in the short run, then the fall in the interest rate will be reduced by an outward shift of the money demand curve caud by the temporarily higher transactions demand for money. In figure 14.3, the increa in the money supply line from (M1/P) to (M经济学经典书籍2/P) is coupled with a shift out in the money demand schedule from L1 to L2. The interest rate falls from its initial value of R1 to R2, rather than to the lower level R3, becau of the increa in output and the resulting outward shift in the money demand schedule. Becau the interest rate does not fall as much when output ris, the exchange rate depreciates by less: from its initial value of E1 to E2, rath
er than to E学生会竞选3, in the diagram. In both cas we e the exchange rate appreciate back some to E4姓全 in the long run. The difference is the overshoot is much smaller if there is a temporary increa in Y. Note, the fact that the increa in Y is temporary means that we still move to the same IP curve, as LR prices will still shift the same amount when Y returns to normal and we still have the same size M increa in both cas. A permanent increa in Y would involve a smaller expected price increa and a smaller shift in the IP curve.
Undershooting occurs if the new short-run exchange rate is initially below its new long-run level. This happens only if the interest rate ris when the money supply ris—that is if GDP goes up so much that R does not fall, but increas. This is unlikely becau the reason we tend to think that an increa in M may boost output is becau of the effect of lowering interest rates, so we generally don’t think that the Y respon can be so great as to increa R.
4. We learned that an increa in domestic money supply caus exchange rate to overs
hoot in the short run and then in the long run with domestic price adjustment the exchange rate reverts to a lower level (but at a level higher than the initial level prevailing before the increa in money supply.) U this knowledge of short-run and long-run effects of a change in domestic money supply to examine both the short-run and long-run effects of an increa foreign money supply on exchange rate.
Answer:
Effects are going to be exactly opposite to the effects of an increa in domestic money supply ($). An increa in foreign money supply (euro) caus exchange rate ($ per euro) to undershoot in the short run and then in the long run with foreign price adjustment the exchange rate reverts to a higher level (but at a level lower than the initial level prevailing before the increa in foreign money supply.
