Use the money market & general monetary model and FX market

Exchange is Australian dollars per pound, E_$/.

U.K

real income (Y) : 10.00 trillion

money supply (M): 50.00 trillion

the price level (P): 10.00,

nominal interest rate (i) is 2.00% per annum.

Australia

real income (Y_$) is 1.00 trillion

money supply (M_$) is AU$10.00 trillion

price level (P_$) is AU$20.00

nominal interest rate (i_$) is 2.00% per annum

They have maintained these long-run levels. UIP holds all the time, and the purchasing power parity (PPP) holds only in the long-run. The half-life of the deviation from the PPP is 4 years (deviation from PPP shrinks by 50% in 4 years).

T (today)

Australian real income falls permanently by 10% (new real income in Australia: Y_$ = 0.90 trillion).

The interest rate in Australia falls to 1% per annum today.

the exchange rate today becomes 2.2848

Assume both countries use the floating exchange rate system.

Calculate:

1.new long-run price level in Australia, P^*_$ (round to 4 decimal places).

2.new long-run exchange rate, E^*_$/ (round to 4 decimal places).

3.expected exchange rate 1 year from today (T+1), E^e_$/ (round to 4 decimal places).

4.real exchange rate today (T), q_$/ (round to 4 decimal places).

5.Based on the half-life of the deviation from PPP, calculate the expected real exchange rate 4 years from today (T+4), q^e_$/,4 (round to 4 decimal places).

6.Following the permanent fall of Australian income by 10%, the price level in Australia is expected to go up by 5% in 4 years (P^e_$,4 = 21.00). Calculate the expected exchange rate 4 years from today (T+4), E^e_$/,4 (round to 4 decimal places).

7.Based on your answers to Q2 - Q6, using time series diagrams below, illustrate how the nominal and real exchange rates, E_$/ and q_$/, change over time in response to the permanent decrease in the Australian real income.