Exercise 3 Consider the Mundell
Fleming model to determine the nominal exchange rate. Imagine now that the aggregate demand of the domestic and foreign economies obeys the following quantitative equation:

Md 5 kPY Md

5 kPY

where Md represents the demand for money, k . 0 is a constant associated to the velocity of money, P is the level of prices, and Y is the output level, in real terms. The variables signed with  represent the foreign economy and have an identical definition.

a. Using purchasing power parity, find the nominal exchange rate as a function of the exogenous variables of the model.

b. Assume now that a positive, exogenous shock in productivity increases the real, long-run output in the domestic and in the foreign markets alike, namely, Y

f 2 Y 5 Yf 2 Y. How does the nominal exchange rate in the domestic economy react to this shock?

c. Now assume that the shock from the previous item affects the domestic and foreign economies in distinct ways. How does the nominal exchange rate in the domestic economy react to this shock if Y

f 2 Y . Yf 2 Y? How does the nominal exchange rate react to this shock if Y

f 2 Y , Yf 2 Y?