Use the foreign exchange and money market diagrams to answer the following questions about the relationship between the Indian rupee (INR) and the Chinese yuan (CNY)

Econ 160B: International Macroeconomics, fall 2022
Due by 11:55PM Oct 14,
uploaded to Canvas-Gradescope (see link to instructions in Canvas-files-homework_assignments)
1. Monetary Approach to Exchange Rates
Suppose you learn that the current exchange rate for the Chinese Yuan is $1 = 6 Yuan.
a. If you expect Chinese monetary growth to be a total of 4% larger over the next ten years than US
monetary growth, what is your best guess as to the exchange rate ten years from now? What theory
underlies your prediction? Explain why we apply this theory here over a long run period, like 10
years, rather than over a short period, say less than a year?
b. If you expect that in addition to the higher money growth rate in China above, you also expect the
output growth rate to be higher in China by 5%. Would you predict that the value of the Chinese
Yuan will appreciate or depreciate relative the dollar (more or fewer yuan per dollar).
2. Interest Rate and Purchasing Power Parities
Suppose that the following conditions all hold: uncovered and covered interest rate parity, real
interest rate parity, relative and absolute purchasing power parity.
And suppose you have the following information:
– The current nominal interest rate for a 1 year deposit in a Brazilian bank is 10%.
– Inflation is expected to be 5 percentage points higher in Brazil than Argentina over the next year.
– The forward exchange rate between Brazil and Argentina is 1.05 (Brazilian real / Argentinian peso).
For each of the following, compute a value using the information above, or state if there is not enough
information given above to do this. Show your work in each case and name which parity conditions
you are using.
a. real exchange rate (Brazil/Argentina)
b. expected future spot exchange rate for one year from now (Brazilian real / Argentinian peso)
c. real interest rate in Brazil
d. current spot exchange rate (Brazilian real / Argentinian peso)
3. Exchange Rate Overshooting
Use the foreign exchange and money market diagrams to answer the following questions about the
relationship between the Indian rupee (INR) and the Chinese yuan (CNY). Let the exchange rate be
defined as rupees per yuan EINR/CNY. Suppose there is a fall in the Indian nominal money supply.
Make the usual assumptions: UIP holds, PPP holds in the long run, prices are sticky in the short run,
a. Assume first that the fall in money supply is temporary (so that the nominal money supply is put back
at its original level in the long run). Illustrate the effects of this in a pair of graphs, one for the Indian
money market and one for the foreign exchange market. Label the initial equilibrium as point A, the
short-run equilibrium point B, and your long-run equilibrium point C.
b. Now assume instead that the fall in money supply is permanent. Illustrate this in a pair of graphs, one
for the Indian money market and one for the foreign exchange market. Label the initial equilibrium
as point A, the short-run equilibrium point B and your long-run equilibrium point C.
c. For the case you just analyzed above (permanent shock), plot a graph for each of the following
variables over time showing the initial equilibrium, short run equilibrium, and the long run
equilibrium: India’s nominal money supply, India’s interest rate, India’s price level, India’s real
money supply, and the exchange rate EINR/CNY.
d. Does the theory of “exchange rate overshooting” apply to the case in part (a) above? How about to
the case in parts (b) and (c)? Explain the economic reason the two cases are different.
e. How does your answer to part (d) change if we assume prices are flexible in the short run?