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INTERNATIONALFINANCEANSWERSTOASSIGNMENT#3FROMCHAPTER141.Question#1fromPage366:Supposethereisareductioninaggregaterealmoneydemand,thatis,anegativeshiftintheaggregaterealmoneydemandfunction.Tracetheshort-runandlong-runeffectsontheexchangerate,interestrate,andpricelevel.Answer:Areductioninrealmoneydemandhasthesameeffectsasanincreaseinthenominalmoneysupply.Infigure14.1,thereductioninmoneydemandisdepictedasabackwardshiftinthemoneydemandschedulefromL1toL2.TheimmediateeffectofthisisadepreciationoftheexchangeratefromE1toE2,ifthereductioninmoneydemandistemporary,oradepreciationtoE3ifthereductionispermanent.Thelargerimpacteffectofapermanentreductioninmoneydemandarisesbecausethischangealsoaffectsthefutureexchangerateexpectedintheforeignexchangemarket.Inthelongrun,thepricelevelrisestobringtherealmoneysupplyintolinewithrealmoneydemand,leavingallrelativeprices,output,andthenominalinterestratethesameanddepreciatingthedomesticcurrencyinproportiontothefallinrealmoneydemand.Thelong-runlevelofrealbalancesis(M/P2),alevelwheretheinterestrateinthelong-runequalsitsinitialvalue.Thedynamicsofadjustmenttoapermanentreductioninmoneydemandarefromtheinitialpoint1inthediagram,wheretheexchangerateisE1,immediatelytopoint2,wheretheexchangerateisE3andthen,asthepricelevelfallsovertime,tothenewlong-runpositionatpoint3,withanexchangerateofE4.RL2L1I2I1231(M/P2)E1E4E2E3E(M/P1)Figure14.12.Question#4fromPage366:Whatistheshort-runeffectontheexchangerateofanincreaseindomesticrealGNP,givenexpectationsaboutfutureexchangerates?Answer:AnincreaseindomesticrealGNPincreasesthedemandformoneyatanynominalinterestrate.Thisisreflectedinfigure14.2asanoutwardshiftinthemoneydemandfunctionfromL1toL2.TheeffectofthisistoraisedomesticinterestratesfromR1toR2andtocauseanappreciationofthedomesticcurrencyfromE1toE2.REInterestParitySchedule(M/P)R1R2M/PL2L1E1E2Figure14.2RE(M1/P)E3E2E1R2R3R1L2L1(M2/P)E4Figure14.33.Question#10fromPage367:Inthediscussionofshort-runexchangerateovershooting,weassumedthatrealoutputwasgiven(fixed).Assumeinsteadthatanincreaseinthemoneysupplyraisesrealoutputintheshortrun.Howdoesthisaffecttheextenttowhichtheexchangerateovershootswhenthemoneysupplyfirstincreases?Isitlikelythattheexchangerateundershoots?(Hint:inFigure14-12aofthebook–themoneydemand–moneysupplydiagram,allowtheaggregaterealmoneydemandscheduletoshiftinresponsetotheincreaseinoutput.)Answer:Ifanincreaseinthemoneysupplyraisesrealoutputintheshortrun,thenthefallintheinterestratewillbereducedbyanoutwardshiftofthemoneydemandcurvecausedbythetemporarilyhighertransactionsdemandformoney.Infigure14.3,theincreaseinthemoneysupplylinefrom(M1/P)to(M2/P)iscoupledwithashiftoutinthemoneydemandschedulefromL1toL2.TheinterestratefallsfromitsinitialvalueofR1toR2,ratherthantothelowerlevelR3,becauseoftheincreaseinoutputandtheresultingoutwardshiftinthemoneydemandschedule.Becausetheinterestratedoesnotfallasmuchwhenoutputrises,theexchangeratedepreciatesbyless:fromitsinitialvalueofE1toE2,ratherthantoE3,inthediagram.InbothcasesweseetheexchangerateappreciatebacksometoE4inthelongrun.ThedifferenceistheovershootismuchsmallerifthereisatemporaryincreaseinY.Note,thefactthattheincreaseinYistemporarymeansthatwestillmovetothesameIPcurve,asLRpriceswillstillshiftthesameamountwhenYreturnstonormalandwestillhavethesamesizeMincreaseinbothcases.ApermanentincreaseinYwouldinvolveasmallerexpectedpriceincreaseandasmallershiftintheIPcurve.Undershootingoccursifthenewshort-runexchangerateisinitiallybelowitsnewlong-runlevel.Thishappensonlyiftheinterestrateriseswhenthemoneysupplyrises—thatisifGDPgoesupsomuchthatRdoesnotfall,butincreases.ThisisunlikelybecausethereasonwetendtothinkthatanincreaseinMmayboostoutputisbecauseoftheeffectofloweringinterestrates,sowegenerallydon’tthinkthattheYresponsecanbesogreatastoincreaseR.4.Welearnedthatanincreaseindomesticmoneysupplycausesexchangeratetoovershootintheshortrunandtheninthelongrunwithdomesticpriceadjustmenttheexchangeraterevertstoalowerlevel(butatalevelhigherthantheinitiallevelprevailingbeforetheincreaseinmoneysupply.)Usethisknowledgeofshort-runandlong-runeffectsofachangeindomesticmoneysupplytoexamineboththeshort-runandlong-runeffectsofanincreaseforeignmoneysupplyonexchangerate.Answer:Effectsaregoingtobeexactlyoppositetotheeffectsofanincreaseindomesticmoneysupply($).Anincreaseinforeignmoneysupply(euro)causesexchangerate($pereuro)toundershootintheshortrunandtheninthelongrunwithforeignpriceadjustmenttheexchangeraterevertstoahigherlevel(butatalevellowerthantheinitiallevelprevailingbeforetheincreaseinforeignmoneysupply.