Klaus Desmet Economics 165 Problem Set 3 Due Date: Thu

Klaus Desmet Economics 165 Problem Set 3 Due Date: Thu 2 August in class 1. Consider the exchange rate model under exible prices. The money supply is initially M1 and until time T1 it is assumed that this money supply will be maintained into the indenite future (forever). Then at time T1 the central bank announces that from T1 onwards the money supply will grow at a strictly positive rate. People believe the announcement of the central bank (and the central bank actually does whatever it said it will do). (a) Draw the path of (i) the money supply (ii) the price level and (iii) the dollar/euro exchange rate. (b) Use the Fisher equation and the money demand equation to explain why the price level jumps at time T1. (c) Use PPP and your answer to (b) to explain why the nominal exchange rate jumps at time T1. (d) Why does the money supply itself not jump at time T1? Give a 2-line short answer. (e) Now slightly change the setup: the central bank still lets the money supply grow at a strictly positive rate from T1 onwards but it now announces at an earlier time T0

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