Question

2. This problem evaluates the short-run asset approach to exchange rates. Assume the foreign price level P* is equal to 1, there is no inflation in either country, and r* is equal to 0.04 or 4%. Nominal money demand, MD, is given by L(i)PY.

?(?)=1−0.5?   Y = 20 M=19.6

Hence the economy is at an initial equilibrium summarized by P = 1 and    E = 1.

A. The central bank decides to stimulate the economy with a one-time permanent increase of the money supply by 2% so M=19.992. Determine the initial impact of this increase on the exchange rate E under the assumptions of the model.

Answer 1

Under the asset market approach exchnage rate equlibrium will depends upon the real rate of rerun when deposts of all deposits domestic and forign gives equal retun caled and interest rate pairity. It equalises the exchange rate through arbitrage activity and interest different will translate into expected depriciation.

Here given equilibrium condition   first we find the domestic interest rate by equating money demand= money supply

?(?)=1−0.5?   Y = 20 M=19.6

L(i)PY implied (1−0.5?)x20x1= 19.6 solving for i

we will get 2-i=1.96 so i=o.o4 or 4%

Now consider if M=19.99 then 2-i=1.99 so i=0.01 or 1%

Given the differences of 3% relative to r* = 4%

a rise in foreign interest rates relative to domestic interest rate causes the foreign currency to appreciate against the domestic currency by 3%.

So domestic currency have a lower interest rate so it will be expected to depricated by 3%.