Question

2. Consider two countries: Japan and South Korea. In 1996 Japan experienced relatively slow output growth (1%), whereas South Korea had relatively robust output growth (6%). Suppose the Bank of Japan allowed the money supply to grow by 2% each year, while the Bank of Korea chose to maintain relatively high money growth of 15% per year. For the following questions, use the simple monetary model (where L is constant). You will find it easiest to treat South Korea as the home country and Japan as the foreign country.

A) What is the inflation rate in South Korea? In Japan?

B) What is the expected rate of depreciation in the Korean won relative to the Japanese yen (¥)?

C) Suppose the Bank of Korea decreases the money growth rate from 15% to 12%. If nothing in Japan changes, what is the new inflation rate in Korea?

D) Using time series diagrams, illustrate how this increase in the money growth rate affects the money supply MK, South Korea’s interest rate, prices PK, real money supply, and Ewon/¥ over time. (Plot each variable on the vertical axis and time on the horizontal axis.)

E) Suppose the Bank of Korea wants to maintain an exchange rate peg with the Japanese yen. What money growth rate would the Bank of Korea have to choose to keep the value of the won fixed relative to the yen?

F) Suppose the Bank of Korea sought to implement policy that would cause the Korean won to appreciate relative to the Japanese yen. What ranges of the money growth rate (assuming positive values) would allow the Bank of Korea to achieve this objective?

Answer 1

A)

Inflation rate in South Korea = Money growth - output growth = 15%-6% = 9%

Inflation rate in Japan= Money growth - output growth = 2%-1% = 1%

B)

Rate of depreciation = Inflation in korea -Inflation in Japan

                                    =9% -1 % =8%

C)

New inflation rate in Korea = 12% - 6% = 6%

D)

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