2. Exchange Rates and Overshooting [10 points] In this question the foreign country has a fixed price level of P*=1 and a fixed interest rate of /". The home country initially has an interest rate /=/*=8% and a price level of P=1. There are no changes in monetary policy in the foreign country at any time. Home and foreign output are assumed fixed at Y and Y* respectively. At present the exchange rate is at its PPP value of E=1 (home per foreign currency). Home real money demand responds to the interest rate in such a way that a 2 percentage point drop in the home nominal interest rate would cause home real money demand to rise by 10%. The home country contemplates a change in monetary policy to increase the home money supply M by 10%. a. At first, let us suppose the increase in M is temporary, and the price level remains anchored at P=1 forever. What is the temporary impact of the policy change on the home interest rate? [2] New Home Interest Rate (temporarily) = % b. Suppose that the policy will endure for one year. According to uncovered interest parity, what will be the expected rate of appreciation of the home currency in that year (approximately)? [2] Expected Rate of Appreciation = c. In this case, what will be the spot exchange rate E today (approximately)? [2] E =. d. Now suppose the policy change is permanent. Assume that prices adjust after one year to their new long-run level. What will be the new long-run (future expected) level of the home price level Pe? Of the home exchange rate E-? [2] P = E = e. In this case, what will be the spot exchange rate E today (approximately)? [2] E =