Instructions – Please read the following instructions carefully:
The due date for assignment 1 is July 26 by 23:59. Assignments must be uploaded
on BrightSpace; Do not email me the assignment.
Type and print your answers. Handwritten assignments will not be marked. You
may hand draw graphs and figures, but you must then scan and upload the
assignment. If you do not have access to a scanner, you may use your phone to take
a picture of your assignment and upload the picture. Make sure the scans and
pictures are clear and of high quality.
Assignment 1 accounts for 10% of the final grade. Late assignments will receive a
grade of zero.
Question 1. Assume that Turkey’s money growth rate is currently 15% and Turkey’s output
growth rate is 9%. Europe’s money growth rate is 4% and its output growth rate is 3%. Also,
assume that the world real interest rate is 1.75%. For the questions below, use the conditions
associated with the general monetary model. Treat Turkey as the home country and define
the exchange rate as Turkish lira per euro, /€.LE
a. Calculate the nominal interest rate in Turkey and in Europe. (1 point)
b. Calculate the expected rate of depreciation in the Turkish lira relative to the euro. (1
point)
c. Suppose the central bank of the Republic of Turkey increases the money growth rate
from 15% to 18%. If nothing in Europe changes, what is the new inflation rate in Turkey? (1
point)
d. Illustrate how the change in (c) affects the following variables: ,,TTMP
real money
supply, Ti
, and L/€E
over time. (2 points)
e. Suppose Turkey wants to maintain a fixed exchange rate relative to the euro. What
money growth rate and nominal interest rate would achieve this objective? (1 point)
Question 2. This exercise considers how the FX market will respond to changes in monetary
policy. For these questions, define the exchange rate as British pounds (£) per euro, £/€E
.
Use the FX and money market diagrams to answer them.
a. Suppose the European Central Bank (ECB) permanently increases its money supply.
Illustrate the short-run (label the equilibrium point B) and long-run effects (label the
equilibrium point C) of this policy. (2 points)
b. Suppose the ECB permanently increases its money supply, but investors believe the
change is temporary. That is, investors don’t adjust their expected exchange rate because
they believe the policy will be reversed before prices adjust. Describe how this situation
would affect the spot exchange rate compared with (a). (1 point)
c. Finally, suppose the ECB announces its plans to permanently increase the money supply,
but doesn’t actually implement such a policy. How will this affect the FX market in the
short run if investors believe the ECB’s announcement? (1 point)