Assume the following initial situation:
R = 3% (annual domestic interest rate), R* = 5% (annual foreign interest rate) E = 2 (current spot rate; expressed as the price of pound in terms of us dollar)
If the domestic money supply increases by 10% and drive the interest rate down by 1% in the short run. What would be the responses of the nominal exchange rate in the short run and long run (show the values of exchange rate in the short and long run)?
(Instructions: 1. domestic interest rate will return to the initial level in the long run, 3% → 2% → 3% 2. Expectation on exchange rate has a one for one relationship with the money supply change)]