THE NOTES ON INTERNATIONAL FINANCEhw2sol160

Econ 160B: International MacroeconomicsSolution key to homework #21. In the long run, the price level equals the ratio of money supply to money demand. A 25% larger increase in the Japanese money supply than in the US money supply implies that the Japanese price level should increase 25% more than the US price level. Relative purchasing power parity in turn implies that the Japanese yen should depreciate by 25% in relation to the dollar in the long run. Thus the exchange rate 10 years from now should be about $1 = 150 yen.2. Which of the following statements refer to absolute PPP, which refer to relative PPP, and which are not related at all to PPP? a. Unrelated to PPP. b. Absolute PPP. c. Relative PPP. d. Relative PPP. e. Unrelated to PPP.3. The Canadian removal of trade restrictions would tend to increase demand for US products which leads to a higher real exchange rate from the Canadian perspective (Canadian goods per US goods). It would also tend to increase the nominal exchange rate (Canadian $ per US $). The increase in money supply would have no effect in the long run on the real exchange rate, but would be expected to increase the nominal exchange rate by 6%. The combined effect is that both real and nominalexchange rates rise, but the nominal rate rises by more than the real rate. From the Irish perspective, the increase in trade restrictions would lower nominal and real exchange rates. The increase in the rate of money growth increases the rate of nominal depreciation of the Irish punt (i.e. increases the rate at which the nominal exchange rate rises). There should be no long run effect from the change in money supply on the real exchange rate. The two effects are somewhat contradictory in terms of the nominal exchange rate, but the real exchange rate will definitely fall.4. Please refer to the following graph.E SF/$ Net returnsReal quantity ofmoney inSwitzerland0 = M S 1/P 1a. A drop in the money supply raises the interest rate from R 0 to R 1. This corresponds to a movementfrom point a to point b in the lower graph.b. By itself, this increase in the interest rate would lower the exchange rate as shown in the upper graphas a movement from point A to point B.c. A permanent drop in the money supply would alter expectations of the long run price level. Agentswould expect a 10% lower price level and (because of PPP) a 10% lower long run value for the exchange rate.d. The change in expected exchange rate shifts the US returns curve in as shown in the upper graph andthe new equilibrium shifts from point B to poi nt C. Again the exchange rate drops.e. In the long run, prices are flexible and the drop in the money supply is fully compensated by a 10%drop in the Swiss price level. Thus the real money supply returns to its original position and the equilibrium in the money market moves back from point b to point a. At the same time the Swiss interest rate returns to its original value. In the asset market, the lower interest rate induces a movement along the US returns curve to point D. Thus the exchange rate increases somewhat.f. There is overshooting here as the exchange rate moved past its new long run position in the short runso it had to reverse directions in the transition from the short to long run.5. The real interest parity condition implies that RE RE e R E e Be Pq q q r r ///−=− (the “Escudo” is the Portuguesecurrency and the “Real” is the Brazilian currency). Thus a difference between the two expected real interest rates implies a change in the expected real exchange rate. The definition of real exchange ratesimply that )()(e B eP e B e P B P r r R R ππ−+−=−. The assumptions in the question imply that both terms in brackets on the right hand side of this equation are positive, so it must be true that the left hand side is also positive. Thus, Portugal’s nominal interest rate should be higher than that in Brazil. To answer the last question, use the previous equation and substitute out for the difference in nominal interestrates from the uncovered interest rate parity condition to get: RE Re e R E e Be Pe Be PE E E r r ///)()(−=−+−ππ.Since Portugal’s inflation is higher than Brazil’s and the real interest rate is higher in Portugal than in Brazil, the Portuguese Escudo should depreciate in nominal terms against the Brazilian Real.4/7/04。