Question

(a) Please use the data below to answer the following questions about how an economy behaves over the long-run. Please show all formulae and calculations in your answer. Nominal money supply growth = 7% p.a. Real income growth = 2% p.a. Real interest rate = 2% Using the same data from part (a), explain what will happen to the value of the nominal exchange rate over the long-run. Assume that inflation in the rest of the world is 2% per annum. Please show all formulae and calculations in your answer.

Answer 1

Consider the given problem here let’s assume that the home money demand function is given by, => Md = (L0/r)*Y*P”, => at the equilibrium “Md=Ms”, => (L0/r)*Y*P=Ms.

=> P = (Ms*r)/(L0*Y), => logP = logMs + logr - logL0 – logY, => dlogP = dlogMs + dlogr - dlogL0 – dlogY, where “dlogL0=0”, => dlogP = dlogMs + dlogr – dlogY.

=> g(P) = g(Ms) + g(r) - g(Y), “g()”, => growth.

Now, according to PPP we can write the following condition.

=> E(H/F) = Ph/Pf, where “Ph=home price” and “Pf=foreign price”.

=> g(E) = g(Ph) – g(Pf), where “g(Ph)” home inflation and “g(Pf)” foreign inflation.

So, given the data the foreign inflation is given by, “g(Pf)=2%” and the home inflation is given by.

=> g(Ph) = g(Mhs) + g(rh) - g(Yh) = 7% + 2% - 2% = 7%.

So, the growth of the exchange rate is given by.

=> g(E) = g(Ph) – g(Pf) = 7% – 2% = 5%, => the exchange rate will increase by “5%”, => the home currency will depreciate by 5%.