Question

(3) Use the uncovered interest parity condition (UIPC) together with the money market equilibrium (MME) equation in order to predict both the short-run and long-run effects of a permanent decrease in real domestic income (Y) on the exchange rate (E), the domestic interest rate (R) and the domestic price level (P).

Answer 1

Uncovered Interest Rate Parity (UIP):- UIP theroy explains the difference in interest rates between two countries will equal the change in currency foreign exchange rates at the same period.
formula:-
Uncovered interest rate parity condition:- It consist of two return steams, one is the foreign money market interest rate on the investment and another is the change in foreign currency rate. It assumes that the country with the higher interest rate will experience a depreciation in its domestic currency compare to the foreign currency.

Money Market Equilibrium (MME):- It appears at the interest rate at which the demand of money equals to supply of money. A change in money demand or supply will lead to a change in the equilibrium interest rate and it changes the level of real GDP and price level.

Diagram

Effects:- 1. Real Domestic Income(Y):- Uncovered interest parity condition (UIPC) and money market equilibrium, both have short run and long run effects on real domestic income. The domestic income will decrease if money supply and interest rate has fallen.

2. Exchange Rate (E):- Exchange rate (E) will be effected in short run and long run by the change in uncovered interest rate parity condition and market supply.

3. Domestic Interest Rate (R):- Domestic interest rate (R) will effect by demand of money and supply of money equilibrium.

4. Domestic Price Level(P) :- The Domestic Price Level will effect by umcovered interest rate parity conditions.