Question

Monetary Approach to the Exchange Rate: 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.

1. 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)

Financial Approach to the Exchange Rate: 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.

2. 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