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):