Consider a world in which prices are sticky in the short-run and perfectly flexible in the long-run. APPP may not hold in the short run but does hold in the long-run. The world has two countries, the U.S. and Japan. Both countries are initially in a long-run equilibrium with fixed money supplies.

a. (20 points) Suppose at time T, real GDP in the United States falls permanently. Draw two diagrams with the money market diagram for the US on the left and the expected return in $/ exchange rate ($/yen) diagram on the right. Label the short-run (impact) effect as point(s) B and the long-run effects as point(s) C.

b. (10 points) What is the immediate effect of the shock in the United States on theU.S. interest rate and the exchange rate ($/yen)? Give two reasons why the exchange rate changes the way it does.

c. (15 points). How do nominal interest rates, prices, and the exchange rate evolve over time? Please use a separate time series diagram for each variable.

d. (5 points) Did the exchange rate "overshoot?" If so, identify the overshooting in your diagram.

2. Suppose instead, real GDP in the United States falls temporarily instead. Contrast the immediate effect of the temporary shock on interest rates and the exchange rate compared to the permanent shock.

a. (20 points) Draw two diagrams with the money market diagram for the US on the left and the expected return in $/ exchange rate ($/yen) diagram on the right. Label the impact effect, when the shock is temporary, as point B and the impact effect when the shock is permanent as point C.

b. (5 points) Why are these impact effects on the exchange rate different? Explain.

c. (5 points) Assuming again that the shock to real GDP in the US was temporary, what would happen to the nominal interest rate in the US and the exchange rate in the long-run. Explain.

I'm confused by the difference in Q1 & Q2. Q1 is the long run effects in which the price level decreases, & in Q2 is the short run effects where the expected return line shifts right temporarily (I think). I don;t understand when Q2 asks for "the impact effect when the shock is permanent as point C." Wouldn't that just be Q1 all over again?

Thanks!