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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. We consider what happens to the euro / $ given a permanent shock to money demand in Europe. We begin initially in a long-run equilibrium with fixed money supplies.
a) (20 points) Suppose at time T, a financial innovation in Europe permanently decreases money demand in Europe. Draw two diagrams with the money market diagram for Europe on the left and the expected return in € / exchange rate (€/$) diagram on the right. Label the short-run (impact) effect as point(s) B and the long-run effects as point(s) C.
b) (15 points) How do nominal interest rates, prices, and the exchange rate evolve over time? Please use a separate time series diagram for each variable.
c) (5 points) Did the exchange rate “overshoot?” If so, identify the overshooting in your diagram.
d) (20 points) Suppose instead that the fall in money demand in Europe is temporary instead. Contrast the immediate effect of the temporary shock on interest rates and the exchange rate compared to the permanent shock. Draw two diagrams with the money market diagram for Europe on the left and the expected return in € / exchange rate (€/$) diagram on the right. Label the impact effect, when the shock is temporary, as point B and the impact effect when the shock is permanent as point C.
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