A.1 Consider a simple asset market model of the exchange rate in which the foreign exchange market is described by Et [t+1] 6t (1 + it) = (1 +21") (UIP) Where it is the UK interest rate, 132' the US interest rate, and at the spot exchange rate (dened as pounds per dollar) at time t. Money market equilibrium in the UK is given by = L (22%) (LM) Where Mt is the money supply, Pt the aggregate price level and Yt aggregate output in the UK at time 15. Money demand L (.) satises 8L/8i 0. Assume that for each period t, output equals its natural rate Yt = 17 and the price level Pt is preset in period t 1. Purchasing power parity is assumed to hold in the long run. Suppose the Bank of England suddenly announces at the beginning of period t = 1 that it will implement a permanent decrease in the level of the money supply M by 35% in period t = 2. Show graphically and explain intuitively how this affects the exchange rate 6,; in periods 1 and 2. What is the percentage change in 6,5 in each period