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.
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.