GS 29280 Spring 2021

International Finance Professor Bae

Assignment 3
Solution

1. N/A.

2. A tilt of spending toward nontraded products causes the real exchange

rate to appreciate as the price of nontraded goods relative to traded goods
rises (the real exchange rate can be expressed as the price of tradables
to the price of nontradables).

3. U.S.

a. Increase in U.S. money supply: PU S rises in proportion to the money

supply; q$/Ž remains the same. All dollar prices will rise (including
dollar price of won).
b. Increase in growth rate of U.S. money supply: Inflation rate, dollar
interest rate, PU S , E$/Ž , rises in proportion to PU S .
c. Increase in world relative demand for U.S. products: E$/Ž falls, and
q$/Ž does as well.
d. Increase in relative U.S. output supply: Dollar depreciates, lowers
relative price of U.S. output, rise in q$/Ž , effect on E$/Ž is not clear
since q$/Ž and PU S work in opposite directions.

Note: If you used Korean variables, then the changes would be opposite
ones.

4. Since the money market adjusts very quickly, the exchange rate rises
immediately to a point on the AA schedule. There will be excess supply
for the domestic currency because the low expected future depreciation
rate of the domestic currency implies that the expected domestic currency
return on foreign deposits is above that on domestic deposits. This excess

1
 supply leads to an immediate increase in the exchange rate (From 1 to
∗∗). However, the point is below the DD schedule. The economy then
moves to point ∗ as output decreases to meet aggregate demand.

E
DD

∗
E∗ •H
YH H ∗∗
•
6
•1 AA

Y∗ Y

5. A temporary tax cut shifts the DD curve to the right and, in the absence
of monetization, has no effect on the AA curve. This is depicted as a shift
′
in the DD curve to DD , with the equilibrium moving from points 0 to 1.
If the deficit is financed by future monetization, the resulting expected
long-run nominal depreciation of the currency causes the AA curve to
′
shift to the right to AA , which gives us the equilibrium point 2. The net
effect on the exchange rate is ambiguous, but output certainly increases
more than in the case of a pure fiscal shift.

2
E
DD
′
DD

0 2
• 1
•
• ′
AA
AA
0 Y