The US money market is given by the quantity theory of money and L(i) = 0.5 3i i= 0.04 P= 50 Y = 20 M= 380 The economy is in a long-term equilibrium, that is, ie = 0.04, pe = 50, Ye = 20, Me = 380. The Forex market is given by the UIP and ieu = 0.04 Peu = 41.7 E = 1.2USD/EUR E = 1.2USD/EUR Now the Fed credibly commits to maintaining the nominal money supply of M=456 forever. (a) Write down the equation that describes the money market today. In it, circle the variable that reflects the Fed's policy and the direction of its change. Then, show which variable adjusts to satisfy the equation. Solve the equation for the interest rate i and find its value now that M=456. Draw a graph of the money market and show the effect of the policy on the other variable with a shift of a curve. (b) Write down the equation that describes the money market in the long term (in expectation terms). In it, circle the variable that reflects the Fed's policy and the direction of its change. Then, show which variable adjusts to satisfy the equation. Express the equation for the price level pe and find its value now that M=456. Draw a graph of the money market and show the effect of the policy on the other variable with a shift of a curve. (c) Focus on the short run implication of your answer to (a) for the exchange rate. Write down the UIP equation. In it, circle ius and indicate its direction of change. Then circle E and indicate its direction of change. Express the UIP equation for E and find its value now that ius = 0.015 or 1.5%. Draw a graph of the forex market and show the effect of a lower ius = 0.015 on E with a shift of a curve. The US money market is given by the quantity theory of money and L(i) = 0.5 3i i= 0.04 P= 50 Y = 20 M= 380 The economy is in a long-term equilibrium, that is, ie = 0.04, pe = 50, Ye = 20, Me = 380. The Forex market is given by the UIP and ieu = 0.04 Peu = 41.7 E = 1.2USD/EUR E = 1.2USD/EUR Now the Fed credibly commits to maintaining the nominal money supply of M=456 forever. (a) Write down the equation that describes the money market today. In it, circle the variable that reflects the Fed's policy and the direction of its change. Then, show which variable adjusts to satisfy the equation. Solve the equation for the interest rate i and find its value now that M=456. Draw a graph of the money market and show the effect of the policy on the other variable with a shift of a curve. (b) Write down the equation that describes the money market in the long term (in expectation terms). In it, circle the variable that reflects the Fed's policy and the direction of its change. Then, show which variable adjusts to satisfy the equation. Express the equation for the price level pe and find its value now that M=456. Draw a graph of the money market and show the effect of the policy on the other variable with a shift of a curve. (c) Focus on the short run implication of your answer to (a) for the exchange rate. Write down the UIP equation. In it, circle ius and indicate its direction of change. Then circle E and indicate its direction of change. Express the UIP equation for E and find its value now that ius = 0.015 or 1.5%. Draw a graph of the forex market and show the effect of a lower ius = 0.015 on E with a shift of a curve
