GS 29280 Spring 2021

International Finance Professor Bae

Assignment 2
Solution

1. This is the definition of money supply from the US government.

(1) M 1 consists of (1) currency outside the U.S. Treasury, Federal Re-
serve Banks, and the vaults of depository institutions; (2) traveler’s
checks of nonbank issuers; (3) demand deposits at commercial banks
(excluding those amounts held by depository institutions, the U.S.
government, and foreign banks and official institutions) less cash
items in the process of collection and Federal Reserve float; and (4)
other checkable deposits (OCDs), consisting of negotiable order of
withdrawal (NOW) and automatic transfer service (ATS) accounts
at depository institutions, credit union share draft accounts, and
demand deposits at thrift institutions.
(2) M 2 consists of M 1 plus (1) savings deposits (including money mar-
ket deposit accounts); (2) small-denomination time deposits (time
deposits in amounts of less than $100,000), less individual retire-
ment account (IRA) and Keogh balances at depository institutions;
and (3) balances in retail money market mutual funds, less IRA and
Keogh balances at money market mutual funds.
** Source: https://www.federalreserve.gov/releases/h6/current/default.htm

2. (1) Open market operations - the purchase and sale of Treasury secu-
rities in the open market by a central bank - are a key tool used
by the Fed in the implementation of monetary policy. When the
Fed purchases Treasury securities in the open market, it increases
the reserves of commercial banks and allows them to increase their
loans and investments. Then the money supply increases. When it
sells them, then it decreases.
(2) The discount rate is the interest rate charged to commercial banks
and other depository institutions on loans they receive from their
regional Federal Reserve Bank’s lending facility. When the Fed low-
ers the discount rate, this increases excess reserves in commercial

1
 banks throughout the economy and expands the money supply. On
the other hand, when the Fed raises the discount rate, this decreases
excess reserves in commercial banks and contracts the money supply.
(3) Reserve requirements are the amount of funds that a depository
institution must hold in reserve against specified deposit liabilities.

3.

a.

Won return Won return

 -

2 2
EŽ
2
/$
- - - - - - •
- EŽ
2
/$ - - - - - - -•
1 3
EŽ
1
/$ - - - - - - - - - - - •
- - - - - - - - - - - E
- Ž/$
3
- - - - - - - - - - - - - - •
-
 Expected - Expected
dollar return dollar return

0 RŽ
2 RŽ
1 0 RŽ
2 RŽ
3

6
S1 S1 ?
MK MK
1
PK • • 1
PK • •

L2 L2
6
?

L1 L3
< Short Run Effects > < Long Run Effects >

Since the decrease in Korean real money demand is temporary, the

economy goes back to the initial equilibrium in the long run.

2
 b.

Won return Won return

-  -
Ž/$ - - - - - - -• -2 - - - - - - - - - - - - - - - Ž- /$
E2 E2 - - - - - - - - •2

EŽ
3 - - - - - - - - - - - -•3
/$

EŽ
1 1
/$ - - - - - - - - - - - •
- -
 Expected - Expected
dollar return dollar return

0 RŽ
2 RŽ
1 0 RŽ
2 RŽ
3

S1
MK
6 2 •
PK
S1
MK 6 6
S1
1
PK • • MK •
1
PK
L2 L2
6

L1
< Short Run Effects > < Long Run Effects >

MS MD
Given RŽ , if real money demand decreases, then ( 1 ) > ( 1 ).
P P
Then, real money demand curve shifts up from L1 to L2 . Thus RŽ
should fall from RŽ1
to RŽ
2
.

Since people know that EŽ/$ would rise, they change their expec-
tation on EŽ/$ (EŽ e
/$ ). This shifts the XE curve right. As the
result, the exchange rate increases further (from 1 to 2). This is the
exchange rate overshooting phenomenon.

MS MD
In the long-run, inequilibrium in the money market, ( 1 ) > ( 1 ),
P P
couldn’t continue if the the decrease in real money demand were

3
 permanent. Thus, price will rise until the real money balances are
the same as before the permanent decrease in the money demand.
Because of this, the interest rate rises again from RŽ
2
to RŽ
3
. Then,
EŽ/$ decreases from EŽ/$ to EŽ/$ .
2 3

c. Refer to lecture slides with permanent decrease in Korean real money

demand.

4.

R¥1 ------- RŽ
1 -------

? R¥ ? RŽ
2 2
------------ ------------

L(R¥ , YJ ) L(RŽ , YK )
0 MJS1 MJS2 0 S1
MK S2
MK
PJ PJ PK PK
- -
< Japanese Money Market > < Korean Money Market >

Won return


EŽ /¥ - - - - - - -• Q
2
k
Q
Q
EŽ
1
/¥ - - - - - - •
- -?- - - •-
 Expected
yen return

0 RŽ
2 RŽ
1

< Foreign Exchange Market >
4
 “The Bank of Korea decides to lower its basic rate (benchmark rate).”
This means that it lowers the discount rate, one of the monetary policy
tools, to increase money supply. Depending on two countries’ relative
policy impacts, the exchange rate may rise, fall, or stay the same because
both countries’ policies are colliding with each other and aim to boost
up their economies.

5. The law of one price, which holds that the prices of goods are the same
in all countries in the absence of transport costs or trade restrictions,
presents an intuitively appealing introduction to long-run exchange rate
determination. What if the law didn’t hold? For example, suppose the
price of pizza sold in one country is $20, while the price of the same
pizza sold in another country is $40. What do you predict will happen?
Many people will buy the $20 pizza, while few will buy the $40 one in
the global market. Due to the price difference, some consumers would
have an incentive to buy pizza at the price of $20 and sell it at the price
of $40 for an easy profit. Due to strong demand and decreased supply,
the price of the $20 pizza would tend to increase. Due to weak demand
and increased supply, the price of the $40 pizza would tend to decrease.
People would have an incentive to adjust their behavior by importing
and exporting pizzas and prices would tend to adjust until one price is
achieved across countries.