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Question 2: (Lesson 6) Consider two economies which we will refer to as the "domestic economy" and the "foreign economy," respectively. Assume that up to time to the two economies are in a long-run equilibrium in which the nominal money supplies in both countries are growing at a 3% annual rate of growth: AM/M = AM*/M* = 0.03. Now assume that at time to the domestic central bank abruptly announces and implements a permanent decrease in the annual rate of growth of the domestic money supply from 3% to ZERO: AM/M = 0.00. Assume that foreign money supply growth remains unchanged at 3%: AM*/M* = 0.03. M b) RI= R*= 0.05- time time E to time time a) Complete panels b), c) and d) in the diagram above to show the effects at time to and after of this change in domestic money supply growth on the domestic interest rate (R), the domestic price level (P), and the exchange rate (E). Base your projections of the behaviour of R, P and E on the assumptions we made in sections 6.1-6.3 of Lesson 6, including that relative purchasing power parity prevails, that inflation is fully anticipated and that all variables adjust immediately to their long-run equilibrium values. [NOTE: You can complete panels b), c) and d) on the exam paper itself or you can first reproduce and then complete them in the exam booklet.] [5 marks] b) Explain the effects of this change in domestic money supply growth on the domestic interest rate (R), and the exchange rate (E). [8 marks] c) A change in domestic monetary policy, such as the one you analysed in parts a) and b), has no effect on the economy's real exchange rate (q). But what if, instead, there is a permanent change in domestic fiscal policy? Use the general model of the real exchange rate in section 6.5 of Lesson 6 to explain how and why a fiscal expansion (either an increase in G, or a cut in 7) will affect the long-run equilibrium real exchange rate. Construct an appropriate diagram to illustrate. [7 marks]