1.

Consider a world in which prices are

sticky in the short-run

and

perfectly flexible in

the long-run

. APPP may not hold in the short run but does hold in the long-run. The

world has two countries, the U.S. and Japan. Both countries are initially in a long-run

equilibrium with fixed money supplies.

a.

(20 points) Suppose at time T, real GDP in the United States falls

permanently. Draw two diagrams with the money market diagram for the US

on the left and the expected return in $/ exchange rate ($/yen) diagram on the

right. Label the short-run (impact) effect as point(s) B and the long-run

effects as point(s) C