Problem Set #4
1) Suppose that the Federal Reserve chooses to increase the money supply by 10%. This is accomplished through a $30B purchase of government securities. Assuming that the monetary approach to exchange rates is the correct approach and that commodity prices are fully flexible (able to adjust to new information), explain the impact of the policy on
· The interest rate
· The price level
· The nominal exchange rate
· The real exchange rate
2) Repeat (1) assuming that the monetary approach is the correct model and that commodity prices are fixed in the short run.
3) Repeat (1) assuming that the portfolio balance approach is the correct approach.
4) Explain how the three exchange rate models deal with nominal exchange rate volatility (i.e. each model has a different explanation for the source of exchange rate fluctuations).
5) Which of the above models do you think is the most realistic? Why?