1. True or False. (Explain your answers.)
a. In the General Monetary Model, a permanent increase in the level of domestic income will cause a discrete drop in the price level and a fall in the inflation rate.
b. If purchasing power parity holds, then real interest rates in different countries should be the same.
2. The Basic Monetary Model: Changes in Growth Rates
Consider two countries, Japan, and Korea. Treat Korea as the home country and Japan as the foreign country, so the exchange rate (E) is measured in won per yen. Suppose that Japan is experiencing relatively slow output growth of $g^* = .02$, whereas Korea has relatively robust output growth of $g = .05$. The Bank of Japan is increasing the money supply $(M^*)$ by $\mu^* = .02$ each year, whereas the Bank of Korea is choosing to maintain a high growth rate of its money supply $(M)$ of $\mu = .10$ per year. Answer the following questions using the basic monetary model, in which $\bar{L}$ and $\bar{L}^*$ are constant.
a. What is the inflation rate in Korea? In Japan?
b. What is the expected rate of depreciation of the Korean won $(\Delta E/E)$?
c. Suppose the Bank of Korea increases the money growth rate from $\mu = .10$ to $\mu = .12$. If nothing in Japan changes, what is the new inflation rate in Korea?
d. Use time series diagrams to depict how this increase in the money growth rate would affect Korea's price level $(P)$, its real money supply $(M/P)$, and exchange rate $(E)$ over time.
e. Now suppose the Bank of Korea decides to fix the exchange rate with the Japanese yen. What money growth rate would the Bank of Korea have to choose to keep the value of the won fixed relative to the yen?
3. The General Monetary Model
Consider again the scenario described in question 3. Now, however, the money demands in Korea and Japan now are inversely related to their respective nominal interest rates. Remember that Korea is the home country. This time the Korean money growth rate is still $\mu = .12$, the Japanese money growth rate is $\mu^* = .02$, the Korean real growth rate is $g = .05$ and the Japanese real growth rate is $g^* = .02$. Assume in addition that the nominal interest rate in Japan is $i^* = .04$.
a. What is the nominal interest rate in Korea?
b. Show that the real interest rate in Korea is equal to the real interest rate in Japan.
c. Suppose the Bank of Korea increases the money growth rate from $\mu = .12$ to $\mu = .15$. If the nominal interest rate in Japan remains unchanged, what will happen to the nominal interest rate in Korea? (Hint: Remember the Fisher effect.)
d. Draw a series of time-series graphs depicting how the increase in the Korean money growth rate would affect (1) the Korean nominal interest rate $i$, (2) the Korean price level $P$, (3) the Korean real demand for money $M^d = L(i)Y$, and (4) the exchange rate $E$ (won per yen).
