Advanced Macroeconomics Martin Weale Class 2 w/b 10th March

1. It is known that the long-run equilibrium exchange rate is £1=$1.20. The interest rate of
sterling is 4% while that on the US$ is 3%. It is expected that this differential will be
maintained for ten years, and after that the sterling interest rate will fall to 3%, in line with
the dollar interest rate
i) How much would you expect the sterling/dollar exchange rate to change between
year 4 and year 5.

ii) What would you expect the current exchange rate to be?

Please calculate your answer taking full account of compounding of interest rates.

iii) The interest rate gap between the United Kingdom and the United States is
expected to decline by one tenth of its value in the previous year, but to take
infinitely long to converge exactly with the dollar rate. What would you expect the
current exchange rate to be?

2. Consider the version of the Dornbusch model set out in Lecture 7. Suppose that φ=1 and
θ=2. Initially y=0, and p=0. i*=0.03. Also p*=q =0.
a) What is the initial interest rate.
b) Suppose the money stock is reduced by 5%. What change is this equivalent to in the log
money stock.
c) What happens to the interest rate.
d) What will be i) the (log) nominal exchange rate and ii) the log price level in the new
equilibrium.
e) What will happen to the nominal and real exchange rate immediately after the reduction
in the money stock?
f) Explain the time profile followed by the interest rate and the exchange rate.
g) What will be the implications for output?