14.02 Problem Set 6Spring 1999, SolutionsMultiple Choice1. b) and d)2. b) and d)3. This question was tricky, there is not a correct answer. Nevertheless the answer that istrue “sometimes” is a). Sometimes refers to periods in which the fixed exchange rateregime is completely credible. So for those of you who answered a), we will take it asgood. Of course, for those of you that say there was no answer we will take it as correct.4. b), c) and d) are the correct answers.Problems1.a)Mπyy*T04% 4% 10 10T14% 4.66% 10.016 10T24% 5.78% 10.027 10T34% 7.07% 10.032 10b)Rate of Growth of Incomet0t10.166%t20.111%t30.046%The growth rate of money increment has a positive impact in the growth rate of income.Income increases from 10 in period zero to 10.032 in period 3. However, the magnitudeof the effect is reduced through time.c) Short run effects of monetary policy tend to be substantial. However, overtime theeffects tend to disappear. The variable that does the adjustment is the inflation rate. Inthis model, inflation in the long run will have the same value as the growth rate of moneysupply. This is something that we see in the equations, inflation jumps from 4% in periodzero to 7.07% in period 3. In the long run, increases in the growth rate of money aretranslated into increments in inflation, leaving employment unchanged.2.a) The indicator is W/EP*, this give you the quantity of consumption baskets that therepresentative household can buy.b) Landlockia’s exchange rate will be appreciated. Interest rate has not change inLandlockia, therefore according to the arbitrage condition, there should be anappreciation of the exchange rate. This will increase the value of the well-being indicator.c) After adopting a fixed exchange rate regime, the type of change in E that would besupported by Landlockia nationals is a revaluation of the exchange rate (an appreciation).This has the same effect on the well-being indicator as in part b).d) The first conclusion is that the level of the exchange rate is related to the level ofhouseholds’ consumption. This example is very simple, but under more generalconditions, changes in the exchange rate affect imports prices and, through prices ofimported intermediate, some domestic good prices. The second conclusion is thatcertainly the long-run and short-run effects of a devaluation (depreciation) or arevaluation (appreciation) are different. In the short-run it is possible to increaseconsumption with an overvalue exchange rate; however, that can not last forever andeventually the exchange rate should depreciate to get trade balance equal zero or
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