You should assume that all the assumptions of the overshooting model given in class hold - that is prices are sticky in the short run but flexible in the long run and so on.Suppose that there are two countries - the U.S and Europe.Interest rates are initially 0.15 in both countries.All adjustments take place over two years.The U.S price level is 100.The U.S exchange rate is initially 1.00.

Assume that the US increases its money supply by ten percent.There is no other change.Using the model developing in class answer the following questions.Assume that all adjustment to the long run take place in two years.

a.What is the long run price level for the U.S?Give a number.

b.What is the long run exchange rate for the U.S? Give a number.

c.Suppose that U.S interest rates fall to 0.05 in the US after the increase in the money supply.What happens to the U.S exchange rate over the next two years after the fall in the interest rate.In other words, what is the change rate in the exchange rate for the two years after the interest rate falls.

d.Given the information in c. and given that the U.S interest rate has dropped to 0.05.What is the expected return on investing in Europe?

e.Given the information in d. what is the expected return on investing in the U.S