Themonetarymodeliiassumethatabsolutepurchasingpowerparityhol

Themonetarymodeliiassumethatabsolutepurchasingpowerparityhol Question3- The Monetary Model II Assume that absolute purchasing power parity holds in the long-run, that the money market clears in each country, and that in both countries the demand for real balances or “liquidity preference” takes the form L=a Y– b I where Y is the log of real income, and I is the nominal interest rate. Derive an expression for the log price level, in the home (US) and foreign country, and for the nominal exchange rate in terms of money supplies, outputs, and interest differentials. Analyze and describe in words the impact for the exchange rate in the long-run of each of the following: a) A tightening of US monetary policy b) A decline in the foreign country’s natural output level c) An increase in the domestic natural output level and explain your answers carefully. The Monetary Model II of exchange rate determination, grounded in the assumption of absolute purchasing power parity (PPP), provides a framework linking money supplies, real income, interest rates, and exchange rates in the long-run. This model assumes that the money market in each country clears, and the demand for real balances (liquidity preference) follows the functional form L = aY – bI, where Y denotes the logarithm of real income and I represents the nominal interest rate. Using these foundations, we can derive explicit expressions for the price levels and exchange rates and analyze their responses to various policy and economic shocks. Derivation of the Price Levels and Exchange Rate In equilibrium, the money market in each country clears when the supply of real balances equals the demand. The real money balances (M/P) are given by the ratio of nominal money supply (M) to the price level (P). Setting the demand for real balances equal to supply, we have: M / P = L = aY – bI Rearranging, the price level in each country can be expressed as: P = M / (aY – bI) Applying this to the home country (denoted with subscript H) and the foreign country (subscript F): P H =M