1.In the short run of a model (Chapter 4), a permanent increase a countryâs money supply lowers the nominal interest rate and causes a nominal depreciation in the currency. In this model, prices are âstickyâ: in the short-run, they are fixed or increasing slowly.(a) In the short-run, how does the increase in the money supply affect the real interest rate? Explain, using the definition of the real interest rate.(b) State the real interest parity condition. In the short-run, what does this condition tell us about how the increase in the money supply affects the current real exchange rate. Hold fixed the expected future real exchange rate.(c) If the âfutureâ referred to in part (b) satisfies the properties of the general long-run model in Chapter 5, then how does the permanent increase in the money supply actually affect the future real exchange rate? Explain. 2. Assume that a countryâs inflation rate increases, but there is no change in its expected real interest rate.(a) How does the nominal interest rate change? Explain.(b) Increased inflation means prices are changing, so the short-run analysis from Chapter 4 is not relevant. But both the interest parity condition and the real interest parity condition still hold (because any long-run equilibrium must also satisfy the conditions for a short-run equilibrium, but not visa versa). Using your answers to 1(c) above, what does the real interest parity condition tell us about how this increased inflation rate affects the current real exchange rate? Explain.(c) State the relation between the nominal exchange rate, E, the real exchange rate, q, and home and foreign price levels, P and P* (the one with E on one side of the equality, and q, P and P* on the other side). What does your answer to part (b) imply about how the increased inflation rate affects the nominal exchange rate?
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