(20 points) Assume that the world consists of only two countries which extensively trade with each other: Brandtlandia and Hollandia. Brandtlandia uses the Thaler as currency, and Hollandia the Guilder, both countries have a flexible exchange rate.

The equilibrium exchange rate (e) is 1.5 Guilder for 1 Thaler (and this is the exchange rate notation you need to use for this question). The exchange rate market is in long-run equilibrium.

a. (3 points) Suddenly Brandtlandia is faced with an annual inflation rate of 2%, while Hollandia has an annual inflation rate of 1.5%. If the exchange rate is flexible, what will be the initial effect on the exchange rate? Explain your answer.

b. (7 points) If the central bank of Brandtlandia wants to bring back the exchange rate to its original long-run level, which two policy options does it have? Explain your answer.

c. (5 points) How would your answers under 5a and 5b look differently if the central bank of Brandtlandia used a fixed exchange rate policy of 2 Guilder for 1 Thaler instead?

d. (5 points) Assume that both countries have flexible exchange rates, no inflation and the current exchange rate is 2.5 Guilder for 1 Thaler. The price of a snow shovel is 20 Guilder in Hollandia, and 15 Thaler in Brandtlandia. Is there purchasing power parity here? Explain your answer. Is the Thaler overvalued or undervalued? What will happen in the long run to the exchange rate? Explain your answer.

Q5 (20 points) 5. (20 points) Assume that the world consists of only two countries which extensively trade with each other: Brandtlandia and Hollandia. Brandtlandia uses the Thaler as currency, and Hollandia the Guilder, both countries have a flexible exchange rate. The equilibrium exchange rate (e) is 1.5 Guilder for 1 Thaler (and this is the exchange rate notation you need to use for this question). The exchange rate market is in long-run equilibrium. a. (3 points) Suddenly Brandtlandia is faced with an annual inflation rate of 2%, while Hollandia has an annual inflation rate of 1.5%. If the exchange rate is flexible, what will be the initial effect on the exchange rate? Explain your answer. b. (7 points) If the central bank of Brandtlandia wants to bring back the exchange rate to its original long-run level, which two policy options does it have? Explain your answer. c. (5 points) How would your answers under 5a and 5b look differently if the central bank of Brandtlandia used a fixed exchange rate policy of 2 Guilder for 1 Thaler instead? d. (5 points) Assume that both countries have flexible exchange rates, no inflation and the current exchange rate is 2.5 Guilder for 1 Thaler. The price of a snow shovel is 20 Guilder in Hollandia, and 15 Thaler in Brandtlandia. Is there purchasing power parity here? Explain your answer. Is the Thaler overvalued or undervalued? What will happen in the long run to the exchange rate? Explain your