2. Suppose that the European Central Bank increases the growth rate of money supply in EU from EU to EU + EU , where EU > 0. Use the real exchange rate model to determine the impact of this policy on the Canadian economy. Perform the analysis from the point of view of the Canadian resident (i.e. treat Canada as the domestic country and EU as the foreign country). (a) Start by considering output markets. What is the eect of an in- creases in the growth rate of money supply in EU on output markets and, hence, on the real exchange rate between Canada and EU? Ex- plain. (b) Use the real exchange rate parity to determine the eect of this policy change on the nominal interest rates in EU and Canada. What is the eect of an increase in European money supply growth on the nominal interest rate in EU and Canada? Explain. (c) Using your answers to (a) and (b) explain eects of this policy on the money markets in Canada and EU. (d) Using your answers to (a), (b) and (c) explain the eect of this policy on the nominal exchange rate between Canadian dollar and Euro (i.e. the eect on E$=C= ). 1

(e) Compare the predictions of this model with the predictions of the model based on PPP.