Consider a world in which prices are sticky in the short-run and perfectly flexible in the long-run. APPP may not hold in the short run but does hold in the long-run. The world has two countries, the U.S. and Japan. Both countries are initially in a long-run equilibrium with fixed money supplies.
a. Suppose at time T, real GDP in the United States falls permanently. Draw two diagrams with the money market diagram for the US on the left and the expected return in $/ exchange rate ($/yen) diagram on the right. Label the short-run (impact) effect as point(s) B and the long-run effects as point(s) C.
b. What is the immediate effect of the shock in the United States on the U.S. interest rate and the exchange rate ($/yen)? Give two reasons why the exchange rate changes the way it does.
c. How do nominal interest rates, prices, and the exchange rate evolve over time? Please use a separate time series diagram for each variable.
d. Did the exchange rate "overshoot?" If so, identify the overshooting in your diagram.