Sorry, this is a little long, hope somebody could give me some help. Thanks in advance.
Consider the exchange rate of the dollar for the euro. Suppose that the liquidity function L(i) is the same
in both the United States and Europe. The United states and Europe are initially in long-run equilibrium.
The money supply in the United States is $1,000, and its real GDP is 10,000 units. The price level in the United States in this long-run equilibrium is $1 per unit of output. The money supply in Europe is 500 euros, and its real GDP is 5,000 units. At time T, the United States permanently (and unexpectedly) increases its money supply to $1,500. At time T, interest rates in the United States fall from 5% to 2%.
1. What is the exchange rate prior to time T?
2. What is the expected future spot rate at time T (after permanent increase in the money supply)?
3. What are the interest rates in Europe before and after time T?
4. What is the expected rate of depreciation/appreciation of the dollar immediate following time T?
5. What is the exchange rate immediately after the permanent increase in the money supply in the United States at
time T?
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