Suppose you are given the following information:
|
Home
|
Foreign
|
|
Labour share of income
|
60%
|
50%
|
|
Technological growth rate (TFP growth)
|
1.4%
|
2.2%
|
|
Growth rate of capital accumulation
|
4%
|
2.4%
|
|
Growth rate of labour
|
5%
|
3.2%
|
|
Growth rate of money supply
|
6%
|
4.7%
|
|
Percentage change in velocity of money
|
2%
|
1.5%
|
In the questions:
1. All the growth rates are annual growth rates.
2. Exchange rate is quoted as the number of units of foreign currency needed to exchange for (buy) one domestic currency unit, eFC/DC.
3. Purchasing power parity holds.
a) Find the growth rate of output in both countries. (Hint: The growth accounting equation).
b) What is the inflation rate in Home? In Foreign?
c) What is the rate of change in the nominal exchange rate? Which currency is expected to appreciate? At what rate? Explain.
Now, suppose the government of Home appoints a new governor to the country's central bank. The newly appointed governor believes that deflation would be harmful to the economy and decides to set an inflation target of 2% per year.
d) What should the central bank of Home do to achieve this inflation target? What would be the new growth rate of domestic money supply? Explain.
e) Redo part (c) with an inflation target of 2% in Home. Now, instead of having an inflation target, the newly appointed governor of Home's central bank wants to keep the nominal exchange rate from changing (i.e., it wants to have a fixed exchange rate).
f) What should the central bank of Home do to keep the exchange rate fixed? What happens to domestic inflation rate? What would be the new growth rate of domestic money supply?