Question

For the following questions imagine a world in which the assumptions of the monetary approach to the exchange rate hold at all times. There are two countries the U.S. and Mexico. Suppose that the real interest rate is 2%. In Mexico, the expected money supply growth rate is 8 percent and the expected real GDP growth rate is 2 percent. In the United States the expected money supply growth rate is 4 percent and the expected real GDP growth rate is 1 percent.

Suppose that the expected rate of growth of the Mexican real GDP increases from 2 percent to 4 percent at time T. Nothing else changes (including the levels of all other variables).

a.What happens to the Mexican interest rate at time T? (Give numbers)

b.What happens to the exchange rate written in Mexican terms at time T? ( No need for numbers)

2) Consider a world in which prices are sticky in the short-run and perfectly flexible in the long-run. APPP may not hold in the short run but does hold in the long-run. The world has two countries, the U.S. and Japan. Both countries are initially in a long-run equilibrium with fixed money supplies.

A) Suppose that real GDP in the United States falls temporarily. What is the impact on the real interest rate and the real exchange rate? Explain how you know.

Answer 1

(a) Since in Mexician rate only the real GDP increase. The interest rate would be stable i. e. , 2%

(b) The expected growth rate increases in Mexico.

(A) If the real GDP will fall the average interest rate will also fall in an economy.

Lower interest rate will reduce the value of country's currency. It will reduce the country's product price when sold export.

The Authority must make the balanced interest rate so that the economy is in the condition of stability.