This question uses the general monetary model, in which L is no longer assumed constant and money demand is inversely related to the nominal interest rate.

Consider the same scenario described in the previous question:

Japan's output growth = 1%, whereas Korea's output growth = 6%. Suppose the Bank of Japan sets the money supply growth rate at 2% each year, whereas the Bank of Korea set a relatively higher money growth of 12% per year.

In addition, the bank deposits in Japan pay a 3% interest rate.

a. Compute the interest rate paid on Korean deposits.

b. Using the definition of the real interest rate (nominal interest rate adjusted for inflation), show that the real interest rate in Korea is equal to the real interest rate in Japan. (Note that the inflation rates you computed in the previous question will be the same in this question.)

c. Suppose the Bank of Korea increases the money growth rate from 12% to 15% and the inflation rate rises proportionately (one for one) with this increase. If the nominal interest rate in Japan remains unchanged, what happens to the interest rate paid on Korean deposits?

d. Using time series diagrams, illustrate how this increase in the money growth rate in Korea affects the money supply, MK; Korea's interest rate; prices, PK; real money supply; and the exchange rate Ewon/¥ over time. (Plot each variable on the vertical axis and time on the horizontal axis.)