Problem:

Consider world in that prices are sticky in the short-run and perfectly elastic in long-run. APPP might not hold in the short run but does hold in long-run. The world has two countries, the U.S. and Japan. Both countries are initially in the long-run equilibrium with fixed money supplies.

Required:

a. Assume at time T, real GDP in United States falls permanently. Sketch two diagrams with the money market diagram for the US on left and the expected return in $/ exchange rate ($/yen) diagram on the right. Label the short-run (impact) effect as point(s) B and long-run effects as point(s) C.

b. What is the immediate effect of shock in United States on the U.S. interest rate and exchange rate ($/yen)? Provide two reasons why the exchange rate alters the way it does.

c. How do prices, nominal interest rates, and the exchange rate evolve over time? Please employ a separate time series diagram for each variable.

d. Did the exchange rate ‘overshoot?’ If so, recognize the overshooting in your diagram.