1. Permanent Money Shock
Use the FOREX and money market diagrams to answer the following questions. This question considers the relationship between the Indian rupees (INR) and the Chinese yuan (CNY). Let the exchange rate be defined as rupees per yuan ER/C. On all graphs, label the initial equilibrium point A.
a. Illustrate how a permanent increase in India’s money supply affects the money and FOREX markets.
Label your short-run equilibrium point B and your long-run equilibrium point C.
b. Using your analysis from above, state how each of the following variables changes in the short run
(increase/decrease/no change): India’s interest rate, China’s interest rate, ER/C, Ee , India’s price level. R/C
c. Using your analysis from above, state how each of the following variables changes in the long run
(increase/decrease/no change relative to their initial values at point A): India’s interest rate, China’s interest
rate, ER/C, Ee , India’s price level. R/C
d. Explain how overshooting applies to the situation analyzed in part a) – d) above. Illustrate how the exchange rate changes over time.
2. Money Demand Shock
Use the FOREX and money market diagrams to answer the following questions. This question considers the relationship between the euro (€) and the U.S. dollar ($). Let the exchange rate be defined as U.S. dollars per euro E$/€. On all graphs, label the initial equilibrium point A. Suppose that with financial innovation in the U.S., real money demand in the U.S. increases, but U.S. money supply remains unchanged.
a. Assume this increase in real money demand is temporary. Using the FOREX/money market diagrams, illustrate how this change affects the money and FOREX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
b. Assume instead this increase in real money demand is permanent. Using a new diagram, illustrate how this change affects the money and FOREX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
c. Using time series diagrams, illustrate how each of the following variables changes over time in response to the permanent increase in real money demand: nominal money supply MUS, price level
PUS, real money supply MUS/PUS, U.S. interest rate i$, and the exchange rate E$/€
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