Teoria y Politica Monetaria, Instructor: Marco Del Negro.

Problem set 7

Question
a) consider an open economy with flexible exchange rates where money supply is constant, and is expected to be constant forever at the level M₀. Output is constant at the level y.
Determine equilibrium prices, inflation, exchange rate and real money balances.
b) in the same economy it is announced in year t (and it is a surprise) that, starting in year t+T=t+10 years from now, money supply will grow at a rate $\mu>0$, and will continue to grow at that rate forever after (also assume that people believe the announcement).
Output is always constant.
Find prices, inflation, exchange rate and real money balances in the new equilibrium (after year 1t+T=t+10)
c) Find the path of real money balances, prices, and exchange rate from year t to year t+T-1 (remember that money supply is kept constant and equal to M₀ in this period).
Describe the equilibrium graphically.
d) Discuss the differences in the path of prices between this equilibrium and the one in which the monetary authorities chooses to fix the nominal exchange rate, albeit temporarily (that is, the `currency crisis' case discussed in class). Explain why many Central Banks have chosen to stabilize the economy by stabilizing the exchange rate, instead of simply stabilizing money supply and letting the exchange rate fluctuate.