Question

Consider two countries, Home and Foreign. Suppose the foreign country experienced a relatively slow output growth (1%), whereas the home had relatively robust output growth (6%). Suppose the Central Bank of foreign country allowed the money supply to grow by 2% each year, whereas the Central Bank of home country chose to maintain relatively high money growth of 12% per year. For the following questions, use the simple monetary model (where L is constant).

a. What is the inflation rate in Home? In Foreign?
b. What is the expected rate of depreciation in the home currency relative to the foreign currency?
c. Suppose the Central Bank of home country increases the money growth rate from 12% to 15%. If nothing in the foreign country changes, what is the new inflation rate in the home country?
d. Suppose the Central Bank of home country wants to maintain an exchange rate peg with the foreign currency. What money growth rate would the Central Bank of home country have to choose to keep the value of its currency fixed relative to the foreign currency

Answer 1

Step-by-step explanation:

a) The quantity theory of money refers that money supply growth is equal to the increase in price plus output growth rate.

Thus, Inflation rate = Money Supply Growth - Output (GDP) Growth

Hence, Inflation in Home is computed as under:

= 12% - 6%

= 6%.

Inflation in Foreign is computed as under:

= 2% - 1%

= 1%.

Therefore, Inflation rate in Home and Foreign are 6% and 1% respectively.

b) The expected rate of depreciation refers to the decrease in the value of home currency relative to the foreign currency. It is computed by the difference of inflation rate between Home and Foreign currency.

Thus, Rate of depreciation = Inflation rate in Home - Inflation rate in Foreign.

Rate of depreciation:

= 6% - 1%

= 5%.

Therefore, the expected rate of depreciation in the Home currency relative to the Foreign currency is 5%.

c) New inflation rate in Home = New money supply growth - Output Growth

New inflation rate in Home country:

= 15% - 6%

= 9%.

Therefore, the new inflation rate in Home country is 9%.

(d) For keeping the exchange rate constant, the Central Bank of Home should lower its money growth rate. This can be computed exactly which money growth rate will keep the exchange rate fixed by using the fundamental equation for the simple monetary model as under:

(µH* - gH) = (µF - gF)

Putting the values given above and solving for µH*:

(µH* - 6%) = (2% - 1%)

µH* = 7%.

Therefore, if the Central Bank of Home country sets its money growth rate to 7%, then its exchange rate with Foreign Country will remain unchanged.