Use the DD-AA model to examine the effects of a one-time rise in the foreign price level, P*. If the...
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1. Use the DD-AA model to examine the effects of a one-time rise in the foreign price
level, P*. If the expected future exchange rate Ee rises immediately in proportion to
P* (in line with PPP), show that the exchange rate will also appreciate immediately in
proportion to the rise in P*. If the economy is initially in internal and external balance,
will its position be disturbed by such a rise in P*l
2. Analyze a transitory increase in the foreign interest rate, R*. Under which type of
exchange rate is there a smaller effect on output—fixed or floating?
3. Suppose now that R* rises permanently. What happens to the economy, and how does
your answer depend on whether the change reflects a rise in the foreign real interest
rate or in foreign inflation expectations (the Fisher effect)?

Jan 25 2021 05:50 PM

1 Approved Answer

Vishwas M
answered on
January 27, 2021

4
Ratings,
(17 Votes)

Answer : 1. An change in P* , given E and P , a rise in P* makes foreign goods and services relatively more expensive . Aggregate demand for domestic output therefore rises and DD shidts to the right . But , AA curve will re,ain unchanged . Hence ,a one-time rise in the foreign price level, P* will shift the DD curve to the right as shown : As shown, Exchange rate appreciates from E1 to E2 and output increases to Y1 to Y2 . Suppose market participants in foreign exchange market suddenely revise their expectation about the exchange ratefuture value, so that Ee rises . Such a change shifts the AA curve to the left . The rise in Ee , therefore results in a propotional appreciation of exchange rate . If the economy is initially in internal and external balance, its position will not be disturbed by such a rise in P* . 2. A transitionary increase in R* raises the expected return on foreign currency deposits and therefore shifts the downward sloping AA schedule to the right . Given output, the domestic currency must deppreciate to restore interest parity. A rise in R* therefore...

s the same effect on AA as a rise in Ee . Hence ,Exchange rate appreciates from E1 to E2 and output increases to Y1 to Y2 as shown Under Fixed exchange rate ,there a smaller effect on output . 3. According to fischer equation : Foreign Nominal exchange rate = Foreign Inflation rate + Foreign real exchange rate Increase inForeign Nominal exchange rate (R*) will either result in an increase inForeign Inflation rate or an increase inForeign real exchange rate. If it results in an increase inforeign real interest rate , then it will results in decrease in domestic price level . On the other hand ,If it results in an increase inforeign inflation , then it will results in an increase in domestic price level according to PPP.

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