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2. Suppose money demand can be described as M/P = 120 - 400i, where i is the nominal interest rate. Assume that the expected future exchange rate equals 2 and that the foreign interest rate equals .05.

a. Suppose the price level equals one and the nominal money supply equals 100. Calculate the nominal interest rate.

b. Calculate the spot exchange rate according to uncovered interest rate parity

c. Suppose there is a temporary increase in the nominal money supply to 110. Assume that the price level remains at one. Calculate the new nominal interest rate.

d. Calculate the new spot exchange rate. (Hint: use the same procedure as part b). Now assume that the increase in the money supply in part c was permanent, not temporary. The foreign country interest rate has not changed.

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Kritika Krishnakumar
Kritika KrishnakumarLv10
28 Sep 2019
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Related questions

Assume the following initial situation:

R = 3% (annual domestic interest rate), R* = 5% (annual foreign interest rate) E = 2 (current spot rate; expressed as the price of pound in terms of us dollar)

If the domestic money supply increases by 10% and drive the interest rate down by 1% in the short run. What would be the responses of the nominal exchange rate in the short run and long run (show the values of exchange rate in the short and long run)?

(Instructions: 1. domestic interest rate will return to the initial level in the long run, 3% → 2% → 3% 2. Expectation on exchange rate has a one for one relationship with the money supply change)]

2. Assume that you are able to borrow $1,000,000 from a local bank. Explain how you could make profits from arbitrage in the following situations. Explain also the amount of profits that you would make, assuming that there are no brokerage or transactions costs.

a. The current dollar-Euro exchange rate (E$/€) is equal to 1.1 in Frankfurt and 1.05 in New York.

b. The dollar-Euro exchange rate (E$/€) = 1.1, the dollar-pound exchange rate (E$/£)= 1.5, and the pound-Euro rate (E£/€ )= .8.

c. The nominal interest rate equals 3% in the U.S. and 1% in Europe, the current dollar-Euro exchange rate (E$/€) is equal to 1, the forward exchange rate (F$/€) is equal to 1.02 and your expected exchange rate one year from now (Ee$/€) equals 1.05.

3. Use the information below to answer question 3.

L M Y

U.S 0.1 2,000 10,000

U.K 0.04 500 5,000

a. Calculate the price levels in both the U.S. and the U.K. according to the quantity theory of money.

b. Calculate the nominal exchange rate (dollars per pound) assuming the quantity theory of money and absolute PPP.

c. Assume that output rises in the U.S. to 11,000. Calculate the new nominal exchange rate.

d. Assume that output in the U.S. is 10,000 but that the money supply rises to 2,200 in the U.S. and to 600 in the U.K. Calculate the new nominal exchange rate.

e. Assume values at the beginning of the problem but assumethat L in the U.K. rises to .06. Calculate the new nominal exchange rate.

The demand for money
A) d and e are correct
B) all of the following are correct
C) decreases as the average selling price of a unit of outputincreases
D) increases as GDP increases
E) is increased by credit card usage
2. The higher the interest rate, the more of their wealth peoplewill hold as money.
A) True
B) False
3. The money demand curve slopes
A) downward because the cost of holding money decreases as theinterest rate decreases
B) downward because the cost of holding money increases as theinterest rate decreases
C) upward because people demand more money as GDP increases
D) upward because people demand more money as GDP decreases
E) downward because people demand more money as the price levelincreases
4. Which of the following, other things constant, will shift themoney demand curve to the left?
A) an increase in the interest rate
B) a decrease in the interest rate
C) a decrease in real GDP
D) an increase in real GDP
E) an increase in the price level
5. An increase in the money supply will
A) increase the demand for money at each interest rate
B) decrease the demand for money at each interest rate
C) lead people to try to exchange money for interest-bearingassets
D) lead people to try to exchange interest-bearing assets formoney
E) increase the interest rate
6. When an increase in the money supply reduces the interest rate,investment and nominal GDP increase.
A) True
B) False
7. In the short run, a decrease in the money supply will cause adecrease in Gross Domestic Product and a decrease in the pricelevel.
A) True
B) False
8. The demand curve for investment is graphed with __________ onthe vertical axis and __________ on the horizontal axis.
A) the interest rate; investment
B) investment; the interest rate
C) the price level; investment
D) investment; the price level
E) real GDP; investment
9. As the interest rate increases,
A) the demand for investment curve shifts to the right
B) the demand for investment curve shifts to the left
C) there is a movement downward along the demand for investmentcurve
D) there is a movement upward along the demand for investmentcurve
E) GDP increases
10. If the economy experiences a contractionary gap and the Fedstimulates the economy, then:
A) The money supply is increasing because the Fed prints moremoney
B) The money supply is decreasing because the Fed hoardsmoney
C) The money supply is increasing because the Fed makes open-marketpurchases
D) The money supply is decreasing because the Fed makes open-marketsales
E) There is no change in the money supply because the Fed cannotinfluence the money supply
11. If the Fed decreases the money supply, GDP
A) increases because the resulting increase in the interest rateleads to a decrease in investment
B) increases because the resulting decrease in the interest rateleads to an increase in investment
C) decreases because the resulting increase in the interest rateleads to a decrease in investment
D) decreases because the resulting increase in the interest rateleads to an increase in investment
E) decreases because the resulting decrease in the interest rateleads to an increase in investment
12. An increase in the money supply can increase the price level,real GDP, or both, but it is impossible to tell exactly what willhappen without knowing the slope of the aggregate supplycurve.
A) True
B) False
13. If the economy experiences an expansionary gap and the Fedsells US government securities in the open-market, then:
A) Money supply increases, investment increases, aggregate demandincreases
B) Money supply increases, the interest rate increases, and theaggregate demand increases
C) Money supply decreases, the interest rate decreases, and theaggregate demand falls
D) Money supply decreases, the investment decreases, and theaggregate demand decreases
E) Interest rate falls, investment falls, aggregate demandincreases
14. If the money supply equals $1,000 and nominal GDP equals$3,000, then V
A) equals 1/3
B) equals 3
C) equals 3 million
D) cannot be determined since we do not know anything aboutprices
E) cannot be determined since we do not know anything about realGDP
15. If the money supply is increasing at a constant 8 percent,velocity is constant, real GDP is increasing at 5 percent, and theinflation rate is 3 percent, which of the following is true?
A) The growth rate of GDP is too low to be maintained.
B) The inflation rate is too low to be maintained.
C) Velocity is too low to be maintained.
D) The money supply growth rate is too low to be maintained.
E) This situation can continue indefinitely.
16. If real output and velocity are stable and predictable, thenthe equation of exchange can be used to derive a simplerelationship between
A) the money supply and the price level
B) the money supply and the interest rate
C) the money supply and the foreign exchange rate
D) velocity and real GDP
E) velocity and nominal GDP
17. For the quantity theory of money to yield usefulpredictions,
A) fiscal policy must be ineffective in altering aggregatedemand
B) fiscal policy must be effective in altering aggregatedemand
C) the economy must be operating at the potential level of realGross Domestic Product
D) velocity must be stable or predictable
E) velocity must be unstable
18. A rising rate of inflation
A) makes people more willing to hold money as an asset
B) reduces the usefulness of money as a store of value and thusincreases the velocity of money
C) increases the usefulness of money as a medium of exchange andthus reduces the velocity of money
D) is usually preceded by a reduction in the money supply
E) does not, apparently, have any effect on the velocity ofmoney
19. There is considerable disagreement about whether the Fedshould
A) engage in open market operations
B) have the power to set reserve requirements
C) reduce the money supply when the economy is growing
D) allow banks to invest in the stock market
E) attempt to control interest rates or should instead attempt tocontrol the money supply
20. For interest rates to remain stable during economic expansions,the growth rate of the money supply should
A) exceed the growth in the demand for money
B) just match the growth in the demand for money
C) be less than the growth in the demand for money
D) be zero
E) just match the growth in nominal GDP


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