Question

Q1 a. Draw a diagram with money demand and money supply curves. Explain why the money demand curve is downward sloping. Find the equilibrium interest rate. b. Shift one of these curves to show if there is a stock market crash in the U.S. and find the new equilibrium interest rate. c. Draw a figure describing both the U.S. money market and the foreign exchange market, analyze the effects of this U.S. stock market crash on the dollar/euro exchange rate.

Q2 Why might the law of one price fail to hold? List three examples.

Q3 Show the relationship between the public saving and the net export based on the absorption approach. What are the effects of the following events on the U.S. GDP and its components? What are the effects of the following events on the U.S. current account and financial account? (1) Apple Company sold $10,000 computers to a German company. (2) The U.S. Government spent 0.5 million dollars on purchasing printing machines made in Japan. (3) The U.S. Government spent 1 million dollars on social security.

Q4 What is interest rate parity? Assume that the euro interest rate is constant at 2 percent, and that the expected exchange rate is 1.05 dollars per euro. Find the expected dollar return on euro deposits for the following cases: (1) The current exchange rate is 1 dollar per euro (2) The current exchange rate is 0.9 dollar per euro (3) The current exchange rate is 1.1 dollar per euro Based on the interest rate parity, what will happen if the dollar interest rate is 1 percent if the current exchange rate is 1 dollar per euro?

Q5 a. What is the exchange rate overshooting model? b. If the Fed announces that they will lower the interest rate by 0.5% next Wednesday, plot the time paths showing its effects on: (a). The dollar interest rate. (b). The U.S. price level. (c). The dollar/euro exchange rate.

Answer 1

1. (a) The demand for money is downwards sloping, which means there is negative relationship between demand for money and nominal interest rate, which is shown by Md. People demand money or like to hold money for two reasons. One is they need to make transaction which is called speculative demand for money and another one is for speculative reasons, when interest rates are lower people like to hold money and wait for the interest rates to increase before they invest their money. And supply for money is a constant, shown by a vertical line Ms. The equilibrium is decided by the intersection of money demand and money supply curve. Below I have shown in the diagram the equilibrium is at point A where equilibrium interest rate is i*.

(b) when there is a stock market crash, the output falls and incomes also falls. With lower income people demand less money. Thus the money demand curve Md shifts to the left. The new money demand curve is Md' and the new equilibrium is decided by the intersection of new money demand curve and money supply curve. In the diagram below the new equilibrium is at point A* where the equilibrium interest rate is at i'. You can notice that the new equilibrium interest rate is below the i* which shows in recession the interest rate is lower.

(C) The impact of stock market crash foreign exchange market can be seen through the interest rate change and how interest parity condition changes to the changes in domestic interest rate.

Let's first understand what interest parity condition is,

R$= R€+ Ee - E/E, here E= exchange rate of euro in terms of dollar.

Which states that when rate of return in two countries when measured in one currency are equal, then there is no incentive for investors to move their money from one country to another. Here R$ is the domestic interest rate and R€ is the interest rate in euro deposits and Ee - E/E is the expected depreciation of dollar against euro. As you can see as Exchange rate goes down the return on euro deposits increase which is reflected by the downwards sloping curve in the upper half of the diagram. The lower half is domestic money market equilibrium and upper half is foreign exchange market equilibrium.

The initial equilibrium was at A* where domestic interest rate was at i* and the equilibrium in foreign exchange market is at point B* where equilibrium exchange rate was at e* . When stock market crashes as we have see in part b the money demand falls and the new equilibrium in domestic money market is at point A' where the equilibrium interest rate is at i'. And the domestic interest rate falls below the interest parity condition interest rate, the investors will move their money to deposit in euro as demand for euro deposit increases the exchange rate depreciates or increases. Because the demand for euro currency has increased. This new equilibrium is shown by point B' and the equilibrium exchange rate is at e'. Which higher than previous foreign exchange equilibrium rate.

Mathematically, as R$ decreases and given that R€ and Ee doesn't change the only thing that will change to restore equilibrium is E. You can see if E increases the right hand side of the interest parity condition also decrease. And E will decrease such that the right and left hand side of the equation becomes equal and the new equilibrium is restored.