QUESTION 1. Monetary Models of Exchange Rate Determination Suppose that PPP and the monetary model describes the long-run behavior of the nominal exchange rate well but fail to describe the short-run behavior. Specifically, in the short run, large deviations from purchasing power parity are observed due to nominal rigidities in goods' prices. Overshooting of the nominal exchange rate in response to monetary shocks occurs as a result. a) What are the three key modeling assumptions used to derive the monetary model of exchange rates? What is the only one of these modeling assumptions which is different in the Dornbusch over-shooting model? b) Write down an equation that reflects the nominal exchange rate solution provided by the monetary model, i.e. express the nominal exchange rate as a function of monetary and real macroeconomic variables and expectations of the future exchange rate. Explain each term. c) Use diagrams and words to describe the impact of a (relative) home country money supply shock for i) the nominal exchange rate, ii) the home interest rate, and iii) the home price level, in the short run, according to the Dornbusch overshooting model, and in the long run, according to the monetary model. Explain carefully why the differences in prediction arise in each case. d) What do each of these two models imply about the ability of monetary policy to influence interest rates, aggregate demand, and GDP in an open economy