Public Affairs 854 - Problem Set 3

Q1. Policy under Floating Exchange Rates in the IS-LM-BP=0 model

Suppose the exchange rate is floating.

1.1. Assume the economy described above is under a floating exchange rate regime. Show graphically what happens if the government decreases government spending.

1.2. Explain your answer to 1.1.

1.3. Now examine a monetary contraction from initial equilibrium, carefully distinguishing between initial impact, and the effect over time.

1.4 Explain why monetary policy has a larger effect in this open economy as opposed to that in a closed economy.

1.5 Answer 1.1, assuming κ = ∞.

Q2. Sticky price monetary model of exchange rates.

2.1 Explain what happens if the monetary authority in US increases the money supply by 3 percent. In your answer, indicate the time paths of M, P, M/P, r-r*, s. Use graphs.

2.2 Suppose θ equals infinity. Redo 2.1.

Q3. Purchasing power parity.

Consider absolute purchasing power parity, in logs (i.e., where lowercase letters denote logged values of uppercase letters):

s_t = p_t - p_t^*

3.1 Explain what happens to the exchange rate if the foreign price level rises by 10%.

3.2 Suppose only relative PPP holds, st = pt - pt* - κ. Answer again 3.1.

3.3 If relative PPP holds, what must be true when US inflation is -3% and foreign inflation is 2%?

4. Using real-world data to evaluate PPP and UIP

Consider the two tables drawn from the Economist, October 31st edition, on the attached pages. Answer these questions using equations, and show your work.

4.1 Using the 3 month interest rates, and assuming UIP holds, calculate the expected change in the dollar/pound exchange rate over the next three months. Be sure to state what the rate will be, in annualized terms, and what will be the actual percentage change in the dollar/pound exchange rate. Show your work.

4.2 Using 10 year bonds, calculate what the implied change in the dollar/pound exchange rate is, over the next ten years.

4.3 Given the empirical evidence on the relationship between exchange rate changes and interest differentials provided in the table in the handout on CIP and UIP, what do you expect to happen to the dollar/pound rate over the next three months, and over the next ten years? Explain.

4.4 Given the inflation rates over the past year, what should have been the rate of change in the US dollar/pound exchange rate if relative purchasing power parity held?  

4.5 The next table is from the Economist, October 10th edition, which reports the results of a poll. Interpret expected inflation rate for 2016 as the expected change from December 2015 to December 2016. What is the expected change in the US dollar/pound over that period if relative PPP holds?

Attachment:- Assignment.rar