International Monetary Economics, Exam 2, March 11, 2020

Your Name: All questions are worth 1 point.

1. Consider the non-equilibrium situation in the money market: People want to reduce their holdings of
monetary asset. In the process toward the equilibrium, answer how variables below will change in the
market: Decrease, Increase, No change.
Price of non-monetary asset: Increase
Interest rate: Decrease
Real money supply: No change
Read money demand: Increase
Answer: Since people want to reduce their holdings of monetary asset, they have more than they want; the
money supply is more than the money demand. So, the situation is like the one below.
R

Current R

Equilibrium R
L(R,Y)
M/P
Real Md MS/P

In the situation, people will buy non-monetary assets, spending the monetary assets they want to reduce.
This means an increase in the demand for non-monetary assets. So, the price of non-monetary asset will
increase. The price increase of non-monetary assets will lower the interest rate (remember that the price of
non-monetary assets and the interest rate are in the negative relationship.) This decrease in the interest rate
will increase the real money demand. But the real money supply will not change.

2. Consider the equilibrium in the model of the FX market and the money market. In cases below, choose
the correct shifts / changes for curves / variables in the model. Events in the cases are temporary.
2.a. Home central bank increased nominal money supply.
Home real money supply curve: Downward, Upward, or No shift
Home real money demand curve: Downward, Upward, or No shift
Home interest rate: Decrease, Increase or No change
Home rate of return curve: Leftward, Rightward, or No shift
Foreign rate of return curve: Leftward, Rightward, or No shift
Home currency: Appreciation, Depreciation, or No change
Answer: Suppose that Home central bank increased the nominal money supply from MS1 to MS2. The figure
below shows what would happen.

E
H.R.R.

F.R.R.

L(R,Y)
MS1/P

MS2/P

M/P
2.b. Home real output fell.
Home real money supply curve: Downward, Upward, or No shift
Home real money demand curve: Downward, Upward, or No shift
Home interest rate: Decrease, Increase or No change
Home rate of return curve: Leftward, Rightward, or No shift
Foreign rate of return curve: Leftward, Rightward, or No shift
Home currency: Appreciation, Depreciation, or No change
Answer: When Home real output fell from Y1 to Y2, the fall would shift up the real money demand curve.
The figure below shows what would happen.

E H.R.R.

F.R.R.
L(R,Y2)
L(R,Y1)
MS/P

M/P

3. Initially, Home economy was in its long-run equilibrium with MS = 100, P = 200, and Ee = 300. Then,
Home central bank changed the nominal money supply to MS = 150. In two cases below, answer the values
of price and the expected exchange rate in the short-run and in the long-run.
3.a. The change in MS was temporary.
Short-run P: 200
Long-run P: 200
Short-run Ee: 300
Long-run Ee: 300
Answer: Temporary changes in nominal monetary supply does not cause any change in the long-run. So,
the long-run price would be 200 and the long-run expected exchange rate would be 300. Moreover, since the
expected exchange rate is the expectation about the long-run value, no change in the long-run means no
change in the short-run, too. So, the short-run expected exchange rate would be 300, too. Lastly, we know
that the price would not change in the short-run.
3.b. The change in MS was permanent.
Short-run P: 200
Long-run P: 300
Short-run Ee: 450
Long-run Ee: 450
Answer: Now, we use the formulas,

∆𝑴𝑺 ∆𝑬𝒆
= in the short-run
𝑴𝑺 𝑬𝒆

∆𝑴𝑺 ∆𝑷
= in the long-run
𝑴𝑺 𝑷

Also, remember that P would not change in the short-run, and the Ee would keep the short-run value in the
long-run. Since MS changed from 100 to 150, MS increased by 50%. So, Ee would increase by 50% in the short-
run and keep the value in the long-run. P would not change in the short-run and increase by 50%.

4. Consider the overshooting in the model of the FX market and the money market. Let E0 be the initial
exchange rate. Suppose that Home central bank permanently increased nominal money supply. Let ES and
EL be the short-run and long-run equilibrium exchange rates after the increase. Choose correct words below.
“ES is (higher / lower) than EL. This is because the increase changes (both interest rate and Ee / only
interest rate / only Ee). So, the exchange rate changes from E0 to ES in the short run. But the change in
(interest rate / Ee) disappears in the long-run. So, the exchange rate (falls / rises) to EL, which is (equal to /
higher than / lower than) E0.”
Answer: See the figure below.
E
H.R.R.
ES

EL
E0
F.R.R.
L(R,Y)
MS1/P

MS2/P

M/P

5. Consider the monetary approach model. Remember how we derived it. Suppose that Foreign real output
YF fell. But monetary approach predicted no change in E because Home interest rate RH changed. Answer
how variables below changed: Decreased, Increased, or No change.
Home interest rate RH: Increase
Foreign price PF: Increase
Home price PH: Increase
Answer: A fall in YF would lower E (Decrease in YF => Decrease in L(RF,YF) => Increase in MSF/L(RF,YF) =>
𝑴𝑺𝑯 /𝑳(𝑹𝑯 ,𝒀𝑯 )
Decrease in 𝑴𝑺𝑭 /𝑳(𝑹𝑭 ,𝒀𝑭 )
). However, the approach predicted no change because RH also changed. This means
the change in RH raised E so that they were cancelled out. Since RH is in L(RH,YH), which is the denominator
of the numerator MSH/L(RH,YH), the change in RH must have lowered L(RH,YH). So, RH must have increased.
For prices, remember that MS/L(R,Y) = P, which is the equilibrium condition in money market. Since YF fell,
MSF/L(RF,YF) increased. So, PF increased. Since RH increased, MSH/L(RH,YH) Increased. So, PH increased, too.

6. Consider the real exchange rate. Suppose that the nominal exchange rate is 30, which is 10% lower than
the level predicted by the absolute PPP. Answer how much the real exchange rate is.
Answer: Remember the formula
𝑷𝑯
E=q × = q × A.PPP.
𝑷𝑭

Since E is 10% lower than the level predicted by the absolute PPP, q is 0.9 (remember that q represents the
deviation of the nominal exchange rate from level predicted by the absolute PPP.)
A. 0.9

7. Consider the model of the relative demand and the relative supply. Suppose that one of the demands in
RD or one of the supplies in RS increased. Because of the increase, one of the curves shifted to the left and
Home currency real-depreciated. Answer which of the demand or supply increased, and which curve shifted
to the left.
Increase: Demand for YH, Demand for YF, Supply of YH, Supply of YF
Curve: RD, RS
Answer: The real-depreciation of Home currency means q increased. Since this increase in q is the result of
the leftward shift of one of the two curves, the curve that shifted is the RD curve. See the figure below.
q RS
RD

Since it was the RD curve that shifted, the increase happened in one of the demands in the RD. Because the
𝑫𝒆𝒎𝒂𝒏𝒅 𝒇𝒐𝒓 𝒀𝑯
leftward shift means RD = fell, the increase happened in the denominator, ie., the demand for
𝑫𝒆𝒎𝒂𝒏𝒅 𝒇𝒐𝒓 𝒀𝑭

YF .
8. Consider the real exchange rate approach. Foreign real output YF changed. At the same time, Home
central bank increased nominal money supply so that the ratio of Home price to Foreign price would not
change. Answer how YF changed: Decreased or Increased, how Foreign price would change: Decrease,
Increase or No change, how Home price would change: Decrease, Increase or No change, how q would change:
Decrease, Increase or No change, and what would the approach predict on Home currency: Appreciation,
Depreciation, No change or No clear prediction.
Change in YF: Decreased
Change in PF: Increased
Change in PH: Increased
Change in q: Increased
Prediction on E: Depreciation
Answer: As pointed out in March 16 lecture, I made a mistake in this question. This question has 5 sub-
questions. On the 5th sub question, in one part I asked about the prediction on Home currency, and in
another part, I asked about prediction on E. So, you do not need to answer that 5th sub question. I graded
this question based on other 4 sub questions. In the following, I answer all sub questions.
𝑴𝑺𝑯 /𝑳(𝑹𝑯 ,𝒀𝑯 )
The equation of the real exchange rate approach is E = q × 𝑴𝑺𝑭 /𝑳(𝑹𝑭 ,𝒀𝑭 )
, where q is the real part and

𝑴𝑺𝑯 /𝑳(𝑹𝑯 ,𝒀𝑯 )

𝑴𝑺𝑭 /𝑳(𝑹𝑭 ,𝒀𝑭 )
is the monetary part. Changes in YF would affect both the real part and the monetary part. To

understand what happened in YF, we use the information “Home central bank increased nominal money
supply so that the ratio of Home price to Foreign price would not change”. Remember the monetary part is
actually PH/PF. Since YF changed, MSF/L(RF,YF) would change. It means PF = MSF/L(RF,YF) would change.
Then, Home central bank increased nominal money supply. This would increase Home price PH =
MSH/L(RH,YH). Since Home central bank did this to keep the ratio of PH/PF constant, PF must have
increased due to the change in YF. Because PF is MSF/L(RF,YF), it means YF must have decreased.
Next, the real part: Since YF decreased, the RS curve (YH/YF) would shift to the right. This would raise q.
So, the real part would increase. Because the monetary part would not change, the approach would predict
an increase in E. It is a depreciation of Home currency.

9. Back to the model of the FX and money markets. Initially Home economy was in the long-run equilibrium
with MS = 200, P = 40, Ee = 60 and Y = 500. Then, Home central bank permanently changed the nominal
money supply to MS = 240. Answer the short-run value of real money supply, the long-run values of real
money supply and the equilibrium real output.
Real money supply in the short-run: 6
Real money supply in the long-run: 5
Equilibrium real output in the long-run: 500
Answer: The formula of the real money supply is MS/P. The nominal money supply in the short-run is MS =
240. Since price would not change in the short-run, P = 40 in the short-run. So, the real money supply in the
short-run is 240/40 = 6. In the long-run, the price would follow the change in the nominal money supply.
Since MS increased by 20%, the price would increase by 20%. So, the real money supply in the long-run would
be 240/48 = 5, which is equal to the its level before the increase in nominal money supply. In the long-run,
the equilibrium real output would be constant. Because Y = 500 in the long-run equilibrium before the
increase in MS, it would be Y = 500 in the long-run equilibrium after the increase, too.

10. Consider the consumption function C(Yd) and the current account function CA(q,Yd). We consider the
short-run only. Suppose that Y, T and E changed in the following way: △Y = 50, △T = 60 and △E = -10.
Answer how variables below would change: Decrease, Increase, No change or Unclear (“Unclear” is for the
case the question does not give enough information to give a clear answer.)
Consumption: Decrease
Imports: Unclear
Current account: Unclear
Aggregate demand: Decrease
Answer: △Y = 50 and △T = 60 means △Yd = 50 – 60 = -10. So, the consumption would fall. Regarding
imports, it is more complicated. The fall in the disposal income would reduce it. But, at the same time, E fell
by 10. This means a real-appreciation of Home currency; it would increase imports. We do not know which
effect is stronger. So, the change in imports is unclear. For current account, again, we do not know how it
would change. So, again unclear. But regarding the aggregate demand, we can figure out how it would change.
Since the disposal income fell, its effect on the aggregate demand is negative (its positive effect on the current
account is overwhelmed by the its negative effect on the consumption). Moreover, the real appreciation of
Home currency by △E = -10 would reduce the current account. So, both changes had negative effects on the
aggregate demand.

11. Y and T changed in the following way: △ Y = 200 and △ T = 300. Because of the changes, the
consumption, current account and the aggregate demand changed. From the numbers below, choose the value
of change for each variable. They must be consistent.
Consumption: -90, -60, 20, 70
Current account: -40, -30, 20, 40
Aggregate demand: -80, -50, 20, 70
Answer: △Y = 200 and △T = 300 means the disposal income fell by 100. So, the consumption must fall,
too: △C = -90 or △C=-60. When the consumption fell, it would raise the current account. So, △CA = 20 or
△CA = 40. We need to check which combination of △C and △CA satisfies △D = △C + △CA with a number
in “Aggregate demand: -80, -50, 20, 70”. Since the disposal income fell, the aggregate demand would fall, too.
So, we just need to check -80 and -50. It is easy to see △C = -90, △CA = 40 and △D = -50 satisfies the
requirement.
12. The texts below describe how to derive the DD schedule. Let E1 and E2 be two exchange rates with E1 <
E2. Choose correct words below to complete the texts.
12.a. “Consider the two curves of aggregate demand, one with E1 and another with E2. The curve with E1 is
(above / below) the curve with E2. Let Y1 and Y2 be the equilibrium real outputs with E1 and E2, respectively.
Because of E1 < E2, Y1 is (greater / smaller) than Y2. This implies that the greater E is, the (greater / smaller)
the equilibrium Y you obtain in the equilibrium of the (FX / Money / output) market.”
Answer: See the figure below for 12.a. and 12.b.

D D=Y
D(E2)

D(E1)

Y
E

E2
(Y2,E2)
E1
(Y1,E1)
Y
Y1 Y2

12.b. Continued from 12.a.

“So, there exists (an equilibrium / a positive) relationship between the exchange rate and the equilibrium
output in the (FX / Money / output) market. Choose the point of (Y1 and E1 / Y1 and E2) and another point (Y2
and E1 / Y2 and E2) in the diagram of Y – E. Connecting two points with a curve and extend it, we can draw
(an upward / a downward) sloping curve. This is the curve of the DD schedule.”