1. Consider two countries, Japan and Korea. Suppose the Bank of Japan allows the money supply to grow by 1% each year, whereas the Bank of Korea maintains relatively high money growth of 6% per year. In both countries, assume that the domestic rate of inflation is equal to domestic money supply growth. Suppose bank deposits in Japan pay 3% annual interest (i.e R ¥ = 3%). For the following questions, use the monetary model of the exchange rate.
a. Compute the interest paid on Korean deposits. Hint: Use the Fisher effect.
b. Using the definition of the real interest rate (nominal interest rate minus the inflation rate), 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 6% to 9% and the inflation rate rises proportionally (one for one) with this increase. If the nominal interest rate in Japan remains unchanged, what happens to the interest rate paid on Korean deposits?