I. (75 points total) Monetary Approach to the Exchange Rate. For the following questions imagine a world in which the assumptions of the monetary approach to the exchange rate hold at all times. There are two countries the US. and Mexico (treat Mexico as the home country). Suppose that the real interest rate is 2%. In Mexico, the expected money supply growth rate is 8 percent and the expected real GDP growth rate is 2 percent. In the United States the expected money supply growth rate is 4 percent and the expected real GDP growth rate is 1 percent. a. (5 points) What is the nominal interest rate in Mexico? 111 the United States? Mexico : ination rate : 8-2:6% this is right, inflation :growth in money supply real gdp growth =.06 US = 3% Mexico Nominal rate is 6+2 = 8% also right nominal i = r+ ination rate US : 5% right, use the same equation for mexico, US ination =.04.01=.03; US i=.02+.03 = .05 (5 points) What is the expected change in the exchange rate in Mexican terms Elma? (1 +8)f(1+5):1.028 = 2.8% increase .06 .03 =.03 =3% The peso should be selling at a forward discount of 3% Suppose at time T, the money supply in Mexico increases by 50% unexpectedly. Nothing else changes (including expectations for the future). Please answer the following questions: C. (5 points) What happens to the Mexican interest rate at time T? Explain your answer. An increase in the money supply will cause an increase in ination , raising the nominal interest rate. Mexico ination becomes .5-.02 =0.48 Nominal interest rate = .48+.02= 0.50 An increase to the money supply causes ination to increase fast, leading to significant nominal rates increase (5 points) What happens to the exchange rate written in Mexican terms at time T? An increase in inflation would decrease the demand for their goods thus decreasing the exchange rate. 0.48-0.03 :U.45 The peso should be selling at a forward discount of 45% (20 points) Draw 4 times series diagrams as we did in the lesson (all referring to Mexican economic variables) with the log of the Mexican money supply