International Finance - Section 3 with answers

Richard Walker, Northwestern University

NOTE: questions 1 & 2 are to be answered using the partial equilibrium framework of the second set of slides.
Question 3 uses the general equilibrium approach of the third set of slides.

1. What is the effect on the current dollar/euro rate of an increase in US GDP, holding constant expectations
of future exchange rates?

Y means a shift in the money demand function and a higher dollar interest rate for a given
real money supply. This will lead E$/e to fall, i.e. the dollar appreciates.

2. Suppose there is a temporary reduction in aggregate real money demand, i.e. an exogenous negative shift in
the aggregate US real money demand function. What will be the impact on todays dollar/euro exchange
rate? How might your answer change if the money demand shift were permanent?

Temporary: money demand shift leads to lower dollar interest rate, and holding constant future
e
expectations E$/e will imply a rise in current E$/e . Permanent: if this money demand shift
persists, we will expect dollar interest rates to remain low, and therefore (by same analysis) will
e
revise future expectations E$/e upwards, i.e. will we expect the dollar to be weaker (than
previously anticipated) in the future. This means that, for UIP to hold, we need an even greater
current depreciation of the dollar than in the case of the temporary money demand shift.

3. Assume that all nominal variables (such as wages) are flexible and thus that US output is equal to its
equilibrium level Y = Y . Also maintain the assumption that nominal variables are constant in the long run,
implying that E = E e in any long-run equilibrium; this in turn implies that R = Rf if our uncovered interest
parity (UIP) equation is to hold. Finally assume the US is a small open economy, so that Rf , Pf and Yf are
all exogenous. These assumptions together imply the following LRGME and LRMME equations:

 
EPf
Y = C [Y T ] + I + G + N X Y , Yf , (LRGME)
P
Ms
= L [Rf , Y ] (LRMME)
P

1
The LRGME equation implicitly defines a long-run equilibrium P/E ratio while the LRMME equation defines
a long-run equilibrium level of P . Together they determine the long-run equilibrium levels of P and E, as in
the following diagram:
P LRGM E

1
P1 = P e LRM M E

E
E1 = E e

What are the separate effects of the following on long-run equilibrium?

(i) a rise in G or a fall in T .

LRGME rotates left to get real appreciation; P unchanged, E .

(ii) a rise in the world interest rate Rf .

LRMME shifts up to get fall in real money supply; P , E .

(iii) an exogenous increase in real money demand.

LRMME shifts down to get rise in real money supply; P , E .

(iv) a fall in the foreign price level Pf .

LRGME rotates right to maintain real exchange rate; P unchanged, E .