Use the DD-AA model to examine the effects of a one-time rise in the foreign price level 1 Use the DD-AA model to examine the effects of a one-time rise in the foreign price level, P* If the expected...

Use the DD-AA model to examine the effects of a one-time

rise in the foreign price level

1 Use the

DD-AA model to examine the effects of a one-time rise in the foreign price

level, P* If the expected future exchange rate rises immediately in proportion

to P* (in line with PPP), show that the exchange rate will also appreciate

immediately in proportion to the rise in P* If the economy is initially in

internal and external balance, will its position be disturbed by such a rise in

P*?

2 If

foreign inflation rates rise permanently, do you expect floating exchange rates

to insulate the Canadian economy in the short-run? How about the long-run? Why?

3 How would

you analyze the use of monetary and fiscal policy to maintain internal and

external balance under a floating exchange rate?

4 Under

what type of exchange rate system, fixed or floating, is there a larger output

effect arising from a transitory increase in the foreign interest rate, R*?

Does your answer change if the increase in R* is permanent? Does it matter if

this increase is due to a rise in foreign real interest rates or a rise in

foreign inflation expectations (the Fischer effect)?