6.1 Consider two economies which we will refer to as the \"domestic economy\" an
ID: 1156290 • Letter: 6
Question
6.1 Consider two economies which we will refer to as the "domestic economy" and the "foreign economy," respectively. Assume that up to time to the two economies are in long-run equilibrium. At time to there is a change in the rate of growth of the domestic money supply (AMiM), while the rate of growth of the foreign money supply stays unchanged at 3% (AM*/M*-0.03). The 4-panel diagram below shows the behaviou, both before and after to, of the domestic money supply (M); the domestic price level (P); the domestic (nominal) interest rate (R); and the exchange rate (E), defined as the domestic-currency price of one unit of foreign currency. Assume that at all times both relative purchasing power parity and interest parity prevail, and are expected to prevail, that inflation is everywhere fully anticipated and that the domestic and foreign expected real interest rates are equal and constant. Finally, assume that all variables immediately adjust to their long-run equilibrium values. Use the information in the diagram and what you have learned in Lesson 6 to answer the following questions. a) R"-0.02 ? to c) time time a) Before time to the domestic interest rate is constant at 2% (R-0.02) while the foreign interest rate is constant at 5% (R" 0.05), but at time to the domestic interest rate rises to match the 5% foreign interest rate. Use Fisher's hypothesis to explain the relationships between the domestic and foreign nominal interest rates both before and after to. (4 marks) b) Before time to the exchange rate (E) is decreasing over time at a constant annual rate but after time t the value of E remains constant. Use the principle of relative purchasing power parity to explain the behaviour of E both before and after to.(4 marks) c) Before time to the expected annual rate of return on a foreign-currency deposit, when measured in domestic currency, emals mark) d) At to there is a upward "jump" in the domestic interest rate (R). That rise in interest rate (tR) (increase/decrease) in domestic real money causes an - (demand/supply). The result is an excess real money supply) which must be eliminated by a "jump" upwards of the /exchange rate) to (demand/supply). There is then a corresponding "jump" upwards of the (demand (price level (increase/decrease) the real money (price level/exchange rate) to keep the real (interest rate/ exchange rate) constant at its value before to. (4 marks)Explanation / Answer
6.1a) The Fisher Effect is a macroeconomic monetary theory which explains the connection between inflation rate and both nominal and real interest rate.Now,in the money market the inflation rate is associated with the money supply.In this instance,the domestic money supply is denoted by M and the domestic nominal interest rate is represented as R.Now according to the "Fisher Effect",Nominal Interest Rate=Real Interest Rate+Inflation rate
It is known that based on Fisher Effect,the inflation rate goes up as the money supply increase.In this case,notice that in Figure a) corresponding to domestic money supply (M),before time t(0),M had been constant and after t(0) the M or the domestic money supply increases thereby increasing the inflation rate as well according to the Quantity Theory of Money.Now,based on the above equation,the increase in inflation rate due to increase in M in figure a),the domestic nominal interest rate R also increases in figure b) after time t(0) which represents the domestic nominal interest rate.Hence,the domestic nominal interest rate R(1) increases from 2% to 5% to catch up with the foreign nominal interest rate R*.Note that here we assume all the macroeconomic conditions of the foreign economy such as foreign money supply,nominal interest rate,inflation rate to be unchanged and only the domestic nominal interest rate changes to catch up with the foreign nominal interest rate.
b) As a result of the increase in domestic money supply the domestic nominal interest rate also rises as explained in part a).Due to increase in the inflation rate,observe that the exchange rate(E) or the domestic currency value of one unit of foreign currency increases after time t(0) and then becomes stable in figure d) whch shows the graph for exchange rate(E).As a result of the increase in E,the foreign goods and services become more expensive for the domestic citizens to purchase as the value of the foreign currency relative to the domestic currency has now also increased.This would lead to low demand for foreign goods and services but alternatively high demand for domestic goods and services for foreign citizens as now the value of domestic currency relative to foreign currency has dropped.Now,observe that the E becomes stable after t(0) and based on Relative Purchasing Power Parity,the domestic goods and services become affordable to the foreign citizens which were more expensive to them befoe time t(0) due to decreasing E in figure d).
c) Before time t(0) the domestic interest rate R* is 0.02 or 2% and the foreign interest rate is R(1)=0.05 or 5%.Thus,the expected annual rate of return on foreign currency deposit in terms of the domestic currency=0.05/0.02=2.5%
d) At t(0) there is an upward "jump" in domestic interest rate(R).The rise in interest rate(R) causes an increase in domestic real money supply .The result is an excess real money supply which must be eliminated by a "jump" upward of the exchange rate to increase the real money demand.There is then a correponding "jump" upwards of the price level to keep the real interest rate constant at its value before t(0).
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.