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 England (treat England as the home country). Suppose that the real interest rate is 2%. In England, the expected money supply growth rate is 3 percent and the expected real GDP growth rate is 1 percent. In the United States the expected money supply growth rate is 4 percent and the expected real GDP growth rate is 2 percent. Please show all work for full credit.

a) (5 points) What is the nominal interest rate in England? In the United States?

b) (5 points) What is the expected change in the exchange rate in English terms E _£/$?

Suppose at time T, the real output in England falls by 20% unexpectedly. Nothing else changes (including expectations for the future). Please answer the following questions:

c) (5 points) What happens to the English interest rate at time T? Explain your answer.

d) (5 points) What happens to the exchange rate written in English terms at time T?

e) (20 points) Use the 4 times series diagrams as we did in the lesson (all referring to English economic variables). (See example below). Please show exactly what happens to these time series variables at time T using real numbers when possible. Please label graphs completely (levels, growth rates, etc).

Now suppose instead (go back to the original conditions) that the expected rate of growth of the English money supply increases from 3 percent to 5 percent at time T. Nothing else changes (including the levels of all other variables).

f) What happens to the English interest rate at time T? (Give numbers).

g) What happens to the level of the exchange rate written in English terms at time T?

h) What happens to the rate of depreciation/appreciation of the British pound, whichever applies?

i) Use the 4 times series diagrams (all referring to English economic variables). Please show exactly what happens to these time series variables at time T using real numbers when possible. Please label graphs completely (levels, growth rates, etc).

Answer 1