Exchange Rate Determination - Short v. Long RunThe nominal money demand for the US is given by the following function:Md = L(i)Y Pwhere Md denotes nominal money demand, L(i) is the liquidity preference function, Y denotes realoutput, and P the price level in the economy. At the same time we can define the liquidity preferencefunction asAL(i)1+iwhere A is a parameter and i denotes the nominal interest rate in the US. Assume that the US econ-omy is initially in equilibrium and that PA = 5.With this information answer the following questions:100, M$ =100 (nominal money supply), Y = 100, and%3D(i) Plot the liquidity preference function with respect to the nominal interest rate i. What kind ofrelation do you observe for the two variables? use economic intuition to explain this relation.(ii) What is the nominal interest rate for the US at the initial equilibrium?(iii) Suppose real output contracts by 5%. If prices are rigid, what is the new equilibrium interestrate in the economy? Is your result intuitive?Assume from now on that the US also interacts with another region in the world, the Eurozone. Forsimplicity we will assume that there are no other countries. Suppose that the nominal interest ratein the Eurozone is 3% and that the expected dollar-euro exchange rate is E.the US is at the initial equilibrium (this is, the one you found in part (ii)).= 1.1. Assume that(iv) Find the spot dollar-euro Es/e exchange rate. (v) Suppose that the European Central Bank increases its interest rate by 1 percentage point (as-sume this is a transitory shock). How will this affect the dollar-euro spot exchange rate Es/?Provide intuition for your results.Now assume that you are the head of the Federal reserve. The economy is slowing down, so youwould like to lower the interest rate. You plan to engage in open market operations to affect the priceof bonds and hence their yield. Suppose that at the initial equilibrium the supply of bonds is equalto 50, and that the demand for bonds is given by100 — 5Рwhere Q is the quantity of bonds demanded by agents in the economy and P is the price of a bonds.(vi) What is the payoff of a bond at the initial equilibrium? Hint: remember that given the yieldand price of the bond you can compute the payoff. The yield at the initial equilibrium is theinterest rate of the economy you found in part (ii).(vii) Suppose that you want to lower the interest rate from the initial one you found in part (ii) to0.5%. If the payoff of the bond stays constant, what should the new price of the bond be inorder to produce a yield consistent with an interest rate of 0.5%?(viii) Using the demand for bonds find the new number of bonds in the market that produces abond price such that the bond yield is 0.5%. Given this, should the supply of bonds increaseor decrease with respect to the initial scenario? Provide intuition for your results. Hint: Youknow the price of the bond such that the yield is 0.5%. You need to determine the quantity ofbonds that households will demand at the new price.(ix) Provide a graphical explanation for what happened between parts (vi) and (viii).

Note: Since this question holds more than three sub-questions, we are restricted to answer first…

where Md denotes nominal money demand, L(i) is the liquidity preference function, Y denotes real output, and P the price level in the economy. At the same time we can define the liquidity preference function as A L(i) = 1+i where A is a parameter and i denotes the nominal interest rate in the US. Assume that the US econ- omy is initially in equilibrium and that P = *. With this information answer the following questions: 100, M$ = 100 (nominal money supply), Y = = 100, and A = (i) Plot the liquidity preference function with respect to the nominal interest rate i. What kind of relation do you observe for the two variables? us economic intuition to explain this relation. (ii) What is the nominal interest rate for the US at the initial equilibrium? (iii) Suppose real output contracts by 5%. If prices are rigid, what is the new equilibrium interest rate in the economy? Is your result intuitive? Assume from now on that the US also interacts with another region in the world, the Eurozone. For simplicity we will assume that there are no other countries. Suppose that the nominal interest rate in the Eurozone is 3% and that the expected dollar-euro exchange rate is Ee the US is at the initial equilibrium (this is, the one you found in part (ii)). = 1.1. Assume that (iv) Find the spot dollar-euro Eş/e exchange rate.

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC