## PROBLEMS

### Question 15.1

1. Use the money market and FX diagrams to answer the following questions about the relationship between the British pound (£) and the U.S. dollar (\$). The exchange rate is in U.S. dollars per British pound E\$/£. We want to consider how a change in the U.S. money supply affects interest rates and exchange rates. On all graphs, label the initial equilibrium point A.

• Illustrate how a temporary decrease in the U.S. money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
• Using your diagram from (a), state how each of the following variables changes in the short run (increase/decrease/no change): U.S. interest rate, British interest rate, E\$/£, , and the U.S. price level P.
• Using your diagram from (a), state how each of the following variables changes in the long run (increase/decrease/no change relative to their initial values at point A): U.S. interest rate, British interest rate, E\$/£, , and U.S. price level P.

### Question 15.2

2. Use the money market and FX diagrams to answer the following questions. This question considers the relationship between the Indian rupee (Rs) and the U.S. dollar (\$). The exchange rate is in rupees per dollar, ERs/\$. On all graphs, label the initial equilibrium point A.

• Illustrate how a permanent increase in India’s money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
• By plotting them on a chart with time on the horizontal axis, illustrate how each of the following variables changes over time (for India): nominal money supply MIN, price level PIN, real money supply MIN/PIN, interest rate iRs, and the exchange rate ERs/\$.
• Using your previous analysis, state how each of the following variables changes in the short run (increase/decrease/no change): India’s interest rate iRs, ERs/\$, expected exchange rate , and price level PIN.
• Using your previous analysis, state how each of the following variables changes in the long run (increase/decrease/no change relative to their initial values at point A): India’s interest rate iRs, ERs/\$, , and India’s price level PIN.
• Explain how overshooting applies to this situation.

### Question 15.3

3. Is overshooting (in theory and in practice) consistent with purchasing power parity? Consider the reasons for the usefulness of PPP in the short run versus the long run and the assumption we’ve used in the asset approach (in the short run versus the long run). How does overshooting help to resolve the empirical behavior of exchange rates in the short run versus the long run?

### Question 15.4

4. Use the money market and FX diagrams to answer the following questions. This question considers the relationship between the euro (€) and the U.S. dollar (\$). The exchange rate is in U.S. dollars per euro, E\$/€. Suppose that with financial innovation in the United States, real money demand in the United States decreases. On all graphs, label the initial equilibrium point A.

• Assume this change in U.S. real money demand is temporary. Using the FX/money market diagrams, illustrate how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
• Assume this change in U.S. real money demand is permanent. Using a new diagram, illustrate how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
• Illustrate how each of the following variables changes over time in response to a permanent reduction in real money demand: nominal money supply MUS, price level PUS, real money supply MUS/PUS, U.S. interest rate i\$, and the exchange rate E\$/€.

155

### Question 15.5

5. This question considers how the FX market will respond to changes in monetary policy in South Korea. For these questions, define the exchange rate as South Korean won per Japanese yen, Ewon/¥. Use the FX and money market diagrams to answer the following questions. On all graphs, label the initial equilibrium point A.

• Suppose the Bank of Korea permanently decreases its money supply. Illustrate the short-run (label equilibrium point B) and long-run effects (label equilibrium point C) of this policy.
• Now, suppose the Bank of Korea announces it plans to permanently decrease its money supply but doesn’t actually implement this policy. How will this affect the FX market in the short run if investors believe the Bank of Korea’s announcement?
• Finally, suppose the Bank of Korea permanently decreases its money supply, but this change is not anticipated. When the Bank of Korea implements this policy, how will this affect the FX market in the short run?
• If a country wants to increase the value of its currency, it can do so (temporarily) without raising domestic interest rates.
• The central bank can reduce both the domestic price level and value of its currency in the long run.
• The most effective way to increase the value of a currency is through surprising investors.

### Question 15.6

6. In the late 1990s, several East Asian countries used limited flexibility or currency pegs in managing their exchange rates relative to the U.S. dollar. This question considers how different countries responded to the East Asian currency crisis (1997–1998). For the following questions, treat the East Asian country as the home country and the United States as the foreign country. Also, for the diagrams, you may assume these countries maintained a currency peg (fixed rate) relative to the U.S. dollar. Also, for the following questions, you need consider only the short-run effects.

• In July 1997, investors expected that the Thai baht would depreciate. That is, they expected that Thailand’s central bank would be unable to maintain the currency peg with the U.S. dollar. Illustrate how this change in investors’ expectations affects the Thai money market and FX market, with the exchange rate defined as baht (B) per U.S. dollar, denoted EB/\$. Assume the Thai central bank wants to maintain capital mobility and preserve the level of its interest rate, and abandons the currency peg in favor of a floating exchange rate regime.
• Indonesia faced the same constraints as Thailand—investors feared Indonesia would be forced to abandon its currency peg. Illustrate how this change in investors’ expectations affects the Indonesian money market and FX market, with the exchange rate defined as rupiahs (Rp) per U.S. dollar, denoted ERp/\$. Assume that the Indonesian central bank wants to maintain capital mobility and the currency peg.
• Malaysia had a similar experience, except that it used capital controls to maintain its currency peg and preserve the level of its interest rate. Illustrate how this change in investors’ expectations affects the Malaysian money market and FX market, with the exchange rate defined as ringgit (RM) per U.S. dollar, denoted ERM/\$. You need show only the short-run effects of this change in investors’ expectations.
• Compare and contrast the three approaches just outlined. As a policy maker, which would you favor? Explain.

### Question 15.7

7. Several countries have opted to join currency unions. Examples include those in the Euro area, the CFA franc union in West Africa, and the Caribbean currency union. This involves sacrificing the domestic currency in favor of using a single currency unit in multiple countries. Assuming that once a country joins a currency union, it will not leave, do these countries face the policy trilemma discussed in the text? Explain.

### Question 15.8

8. During the Great Depression, the United States remained on the international gold standard longer than other countries. This effectively meant that the United States was committed to maintaining a fixed exchange rate at the onset of the Great Depression. The U.S. dollar was pegged to the value of gold, along with other major currencies, including the British pound, French franc, and so on. Many researchers have blamed the severity of the Great Depression on the Federal Reserve and its failure to react to economic conditions in 1929 and 1930. Discuss how the policy trilemma applies to this situation.

156

### Question 15.9

9. On June 20, 2007, John Authers, investment editor of the Financial Times, wrote the following in his column “The Short View”:

The Bank of England published minutes showing that only the narrowest possible margin, 5–4, voted down [an interest] rate hike last month. Nobody foresaw this…. The news took sterling back above \$1.99, and to a 15-year high against the yen.

Can you explain the logic of this statement? Interest rates in the United Kingdom had remained unchanged in the weeks since the vote and were still unchanged after the minutes were released. What news was contained in the minutes that caused traders to react? Explain using the asset approach.

### Question 15.10

10. We can use the asset approach to both make predictions about how the market will react to current events and understand how important these events are to investors. Consider the behavior of the Union/Confederate exchange rate during the Civil War. How would each of the following events affect the exchange rate, defined as Confederate dollars per Union dollar, EC\$/\$?

• The Confederacy increases the money supply by 2,900% between July and December 1861.
• The Union Army suffers a defeat in Battle of Chickamauga in September 1863.
• The Confederate Army suffers a major defeat with Sherman’s March in the autumn of 1864.