Question 3

This problem deals with the link between the Australian and British (UK) money markets and the foreign exchange market. Let EAUD/ be the nominal exchange rate between the Australian dollar and the British pound () and assume that PAUS: PUK, and YAUS are given. Suppose there is a temporary DECREASE in the level of income in the UK (a DECREASE in YUK). Note that in this problem Australia is the Home country and the UK is the Foreign country. 3.a) (12 points) EXPLAIN how this DECREASE in YUK affects the money market, the interest rate, the real supply of money and the real demand for money in the UK. Use a diagram of the money market and the equilibrium equation of the money market to support your answer. Do not forget to explain why the curves shift and why the variables change. 3.b) (4 points) EXPLAIN how this DECREASE in YUK affects the money market, the interest rate, the real supply of money and the real demand for money in Australia. 3.c) (14 points) EXPLAIN how this DECREASE in YUK affects the foreign exchange market, the nominal rate between between the Australian dollar and the British pound (EAUD/f), and the real exchange rate between these two countries. Use a diagram of the foreign exchange market and the uncovered interest parity to support your answer. Do not forget to explain why the curves shift and why the variable change