Case Study:
Use the money market with the general monetary model and foreign exchange (FX) market to answer the following questions. The questions consider the relationship between the US dollars (U) and the Australian dollar (A). Let the exchange rate be defined as Australian dollars per 1 USD, EA/U. In the US, the real income (YUS) is 100 trill., the money supply (MUS) is US$50 trill., the price level (PUS) is US$5 trill., and the nominal interest rate (iUS) is 0.5% per annum. In Australia, the real income (YAU) is 10 trill., the money supply (MAU) is AU$6.5 trill., the price level (PAU) is AU$1.3, and the nominal interest rate (iAU) is 0.5% per annum. These two countries have maintained these long-run levels. Thus, the nominal exchange rate (EA/U) has been 1.30. Note that the uncovered interest parity holds all the time and the purchasing power parity holds only in the long-run. Assume that the new long-run levels are achieved within 1 year from any permanent changes in the economies.Now, today at time T, the US money supply fell permanently by 5% so that the new money supply in the US becomes MUS = US$47.5 trill. With the new money supply, the interest rate in the US. Rose to 1% per annum today.
1. Consider that Australia and the US use a floating exchange rate system
Question 1: Calculate the US price level in 1 year (the new long-run price level in the U.K.), PeUS.
Question 2: Calculate the expected exchange rate in 1 year (the new long-run exchange rate), EeA/U (round off to three decimal places).
Question 3: Calculate the exchange rate today, EA/U (round off to three decimal places).
Question 4: Based on your answers to (b) and (c), using time series diagrams below, illustrate how the exchange rate, EA/U changes over time in response to the permanent decrease in the US money supply.
Be sure to
(i) label all axis,
(ii) draw vertical dashed lines for time T and T+1 year,
(iii) draw horizontal dashed lines for the initial long-run equilibrium as shown in the diagrams below and
(iv) draw the horizontal dashed lines for the new long-run equilibrium to get full marks.
2. Now assume that Australian dollar is pegged to the U.S dollars with the exchange rate of EA/U = 1.3. TheReserve Bank of Australia (RBA) maintains this exchange rate all the time.
A) What should be the interest rate in Australia today, iAU, to maintain the par value of the exchangerate at AU$1.3 per US$1? Explain the reason.
(B) ShouldtheRBAraiseorreducethemoneysupplyinAustraliatodaytomaintaintheparvalueof the exchange rate at AU$1.3 per US$1? Explain the reason, with the aid of a fully labelled Money market and FX diagram. On your diagram, label the initial equilibrium as A, the short run point as B, and the long run equilibrium as C .
(C) What should be the Australian money supply in the long-run to maintain the par value of the exchange rate at $2 per £1? Explain the reason.