5.1 This question makes use of the model of prices, interest rates, and exchange rates in Lesson 5 and embodies all of the assumptions and economic principles of that model.Consider an economy which is initially in a long-run equilibrium. There is then a permanent 10% decrease in the domestic nominal money supply from M¹ to M² = 0.9M¹. Assume that there are no changes in domestic output (Y^f), the foreign interest rate (R*), or the foreign price level (P*).

a) As the economy adjusts from its initial long-run equilibrium to a new SHORT-run equilibrium in response to this permanent decrease in domestic money supply:

i) the domestic price level (P) will ___________(rise/fall/ not change);

ii) the domestic interest rate (R) will __________(rise/fall/not change);

iii) the expected exchange rate (E^e) will ___________(rise/fall/not change);

iv) the actual exchange rate (E) will ___________(rise/fall/not change).

(4 marks)

b) In the spaces below explain WHY each of the following variables will rise, or fall, or not change in the short-run in response to this permanent decrease in nominal money supply.(4 marks)

i) The domestic interest rate (R):

ii) The actual exchange rate (E):

c) Assume that the economy is initially in a long-run equilibrium in which:

Y^f= 100; P*=1.25; M¹= 50; R¹ = R* = 0.05; P¹ = 2.50; E¹ = E^e1= 2.0

Assume that the domestic real money demand function takes the following specific form:

M^d/P = 0.25Y^f - 100R,

Now suppose that the nominal money supply of this economy undergoes a one-time, permanent decrease from M¹= 50 to M² = 45, with no changes in Y^f, P*, or R*.Calculate (rounded to 3 decimal places) the values of domestic interest rate (R) and exchange rate (E) which are consistent with the new short-run equilibrium after this decrease in money supply and enter these values in the table below.(2 marks)

Variable New Short-run Equilibrium Value

R

E

d)In the space below show and/or explain your method of calculation of the short-run equilibrium values of R and E, as recorded in the table above.(4 marks)

e) You have shown and explained how this permanent decrease in money supply will cause a change in the short-run equilibrium exchange rate. Other things being equal, this short-run change in the exchange rate (E) causes domestic goods to be ________________ (overpriced/underpriced) relative to foreign goods, resulting in a(n) _______________ (increase/ decrease) in the domestic current account balance. The resulting excess ______________ (demand for /supply of) domestic output leads in the long run to a __________(rise/fall) in the domestic price level. This change in the domestic price level, in turn, causes a(n)______________(increase/decrease) in real money ____________ (demand/supply) resulting in a __________(rise/fall) in the domestic interest rate from its short-run equilibrium level to its long-run equilibrium level and a consequent ___________(rise/fall) in the exchange rate from its short-run equilibrium level to its long-run equilibrium level.(4 marks)

f) In the new long-run equilibrium, the new long-run equilibrium price level (P) of the economy will equal ____________ and the new long-run equilibrium exchange rate (E) will equal _____________.(2 marks)