Use the money market with the general monetary model and foreign exchange (FX) market to answer the following questions. The questions consider the relationship between the U.K. pound () and the Australian dollar ($). Let the exchange rate be defined as Australian dollars per pound,E$/. In the U.K., the real income (Y) is 10.00 trill., the money supply (M) is 50.00 trill., the price level (P) is 10.00, and the nominal interest rate (i) is 2.00% per annum. In Australia, the real income (Y$) is 1.00 trill., the money supply (M$) is AU$10.00 trill., the price level (P$) is AU$20.00, and the nominal interest rate (i$) is 2.00% per annum. These two countries have maintained these long-run levels. Note that the uncovered interest parity (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, that is, the deviation from PPP shrinks by 50% in 4 years.

Now, consider timeT(today) when the Australian real income fallspermanentlyby 10% unexpectedly so that the new real income in Australia becomes Y$= 0.90 trill. With the new real income, the interest rate in Australia falls to 1% per annum today. With these changes, the exchange rate today becomes 2.2848, (E$/= 2.2848). Assume that Australia and the U.K. use the floating exchange rate system.

a .Calculate the new long-run price level in Australia,P*$(round to 4 decimal places).

b.Calculate the new long-run exchange rate,E*$/(round to 4 decimal places).

c. Calculate the expected exchange rate 1 year from today (T+1),Ee$/(round to 4 decimal places).

d. Calculate the real exchange rate today (T),q$/(round to 4 decimal places).

e. Based on the half-life of the deviation from PPP, calculate the expected real exchange rate 4 years

from today (T+4),qe$/,4(round to 4 decimal places).

f. Using themoney market for Australiaand the FX market diagrams below (replicate them in your answer book), illustrate how this change (the permanent decrease in real income in Australia) affects the money market for Australia and FX markets. Label yourshort-run equilibrium point as Band yourlong-run equilibrium point as C. Be sure to usethe Australian money marketand the exchange rate defined asAU$ per ,E$/. Also be sure to label all curves and equilibrium levels in the diagramsto get full marks.