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2. Consider the over-shooting model we studied in class: Prices are sticky in the short run while PPP holds in the long run. For our purposes, define the short run as one period, and the long run as two periods or more. Focus on the US perspective only. Suppose that both the UK and rest-of-world (ROW) markets are initially in equilibrium in period 0. Then in period 1 the Bank of England announces that it will decrease its money supply in the future. That is, in period 1 there is no change in the money supply; only the news that the money supply will permanently decrease beginning in period 2. (a) For the United States, use the graph below (or make your own) to set up the initial equilibrium for the UK markets in period 0. Plot and label the initial curves for (i) the UIP condition, (ii) supply of real money balances, and (iii) the demand for real money balances. Indicate the initial equilibrium in each market. United States (b) In the same graph you used for part (a), indicate any shifts in curves and show the equilibrium in the short run (period 1). What happens to the UK interest rate (increase or decrease) and exchange rate (appreciate or depreciate)?

          2. Consider the over-shooting model we studied in class: Prices are sticky in the short run while PPP holds in the long run. For our purposes, define the short run as one period, and the long run as two periods or more. Focus on the US perspective only. Suppose that both the UK and rest-of-world (ROW) markets are initially in equilibrium in period 0. Then in period 1 the Bank of England announces that it will decrease its money supply in the future. That is, in period 1 there is no change in the money supply; only the news that the money supply will permanently decrease beginning in period 2.
(a) For the United States, use the graph below (or make your own) to set up the initial equilibrium for the UK markets in period 0. Plot and label the initial curves for (i) the UIP condition, (ii) supply of real money balances, and (iii) the demand for real money balances. Indicate the initial equilibrium in each market.
United States
(b) In the same graph you used for part (a), indicate any shifts in curves and show the equilibrium in the short run (period 1). What happens to the UK interest rate (increase or decrease) and exchange rate (appreciate or depreciate)?

2. Consider the over-shooting model we studied in class: Prices are sticky in the short run while PPP holds in the long run. For our purposes, define the short run as one period, and the long run as two periods or more. Focus on the US perspective only. Suppose that both the UK and rest-of-world (ROW) markets are initially in equilibrium in period 0. Then in period 1 the Bank of England announces that it will decrease its money supply in the future. That is, in period 1 there is no change in the money supply; only the news that the money supply will permanently decrease beginning in period 2.
(a) For the United States, use the graph below (or make your own) to set up the initial equilibrium for the UK markets in period 0. Plot and label the initial curves for (i) the UIP condition, (ii) supply of real money balances, and (iii) the demand for real money balances. Indicate the initial equilibrium in each market.
United States
(b) In the same graph you used for part (a), indicate any shifts in curves and show the equilibrium in the short run (period 1). What happens to the UK interest rate (increase or decrease) and exchange rate (appreciate or depreciate)?

Added by Kate M.

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