Question 2 Suppose that uncovered interest parity holds all the time (both in the short run and in the long run), while the purchasing power parity holds only in the long run, because prices are sticky in the short run. Consider an economy characterized by a demand for money of the form: The variable Y denotes output and R is the domestic interest rate. Assume Y-2 and R-0.1 (ie 10%) Domestic money supply, Ms, is 20. The foreign interest rate is R*-0.05 (ie 5%). The exchange rate of domestic country (domestic currency per foreign currency) is 1/2. (a) Calculate the long run domestic price level P and the foreign price level P*. (b) Now suppose the domestic central bank temporarily increases its money supply to 22 for one period What's the corresponding domestic interest rate, nominal exchange rate, and real exchange rate? Graph this change in the domestic money market and the foreign exchange. (c) Now suppose the domestic central bank permanently increases its money supply to 22. Assume that in the long run the domestic price level full adjusts so that real money demand is the same as before this increase in the money supply. What are the long-run levels of the domestic interest rate, price level, nominal exchange rate, and expected nominal exchange rate, as well as the real exchange rate? (d) Same as in (c), the domestic central bank permanently increases its money supply to 22. Assume that in the short run prices are sticky and do not change. What are the short-run levels of the domestic interest rate, price level, nominal exchange rate, and real exchange rate? (e) Graph the time paths of money supply, price level, interest rate, nominal exchange rate, and real exchange rate for the domestic economy after the permanent increase in money supply. (f) Explain how overshooting applies to this situation. Question 2 Suppose that uncovered interest parity holds all the time (both in the short run and in the long run), while the purchasing power parity holds only in the long run, because prices are sticky in the short run. Consider an economy characterized by a demand for money of the form: The variable Y denotes output and R is the domestic interest rate. Assume Y-2 and R-0.1 (ie 10%) Domestic money supply, Ms, is 20. The foreign interest rate is R*-0.05 (ie 5%). The exchange rate of domestic country (domestic currency per foreign currency) is 1/2. (a) Calculate the long run domestic price level P and the foreign price level P*. (b) Now suppose the domestic central bank temporarily increases its money supply to 22 for one period What's the corresponding domestic interest rate, nominal exchange rate, and real exchange rate? Graph this change in the domestic money market and the foreign exchange. (c) Now suppose the domestic central bank permanently increases its money supply to 22. Assume that in the long run the domestic price level full adjusts so that real money demand is the same as before this increase in the money supply. What are the long-run levels of the domestic interest rate, price level, nominal exchange rate, and expected nominal exchange rate, as well as the real exchange rate? (d) Same as in (c), the domestic central bank permanently increases its money supply to 22. Assume that in the short run prices are sticky and do not change. What are the short-run levels of the domestic interest rate, price level, nominal exchange rate, and real exchange rate? (e) Graph the time paths of money supply, price level, interest rate, nominal exchange rate, and real exchange rate for the domestic economy after the permanent increase in money supply. (f) Explain how overshooting applies to this situation
