Exchange rate overshooting
a. Suppose there is a permanent 10% increase in M in a closed economy. What is the effect on the price level in the medium run?
In a closed economy, we said that money was neutral be- cause in the medium run, a change in the money stock affected only the price level. A change in the money stock did not affect any real variables. A change in the money stock is also neutral in an open economy with flexible exchange rates. In the me- dium run, a change in the money stock will not affect the real exchange rate, although it will affect the price level and the nominal exchange rate.
b. Consider an open economy with a flexible exchange rate. Write the expression for the real exchange rate. Suppose there is a 10% increase in the money stock and assume that it has the same effect on the price level in the medium run that you found in part (a). If the real exchange rate and the foreign price level are unchanged in the medium run, what must happen to the nominal exchange rate in the medium run?
c. Suppose it takes n years to reach the medium run (and everyone knows this). Given your answer to part (b), what
Suppose that, despite the change in the expected exchange rate, the government keeps the exchange rate fixed today. Let UIP stand for the uncovered interest parity condition.
b. Draw an IS-LM-UIP diagram. How does the change in the expected exchange rate affect the UIP curve? As a result, how must the domestic interest rate change to maintain an exchange rate of E ?
c. Given your answer to part (b), what happens to the do- mestic money supply if the central bank defends the fixed exchange rate? How does the LM curve shift?
d. What happens to domestic output and the domestic inter- est rate? Is it possible that a government that was previ- ously committed to a fixed exchange rate might abandon it when faced with a fear of depreciation (either through devaluation or abandonment of the fixed exchange rate regime)? Is it possible that unfounded fears about a depre- ciation can create a crisis? Explain your answers.