University of Warwick
EC312 – International Economics
Autumn 2015 – Natalie Chen
Problem Set 3
Exercise 1
Consider the Monetary Model of exchange rate determination with ‡exible prices. Money demand in the domestic (foreign ¤ ) economy is given by the Cambridge quantity equation:
½
  =  
 ¤ =  ¤  ¤ ¤
¡
¢
where    ¤ is domestic (foreign) money demand,  ( ¤ ) is the domestic (foreign) price
level,  ( ¤ ) is real domestic (foreign) income and  (¤ ) is a parameter (inverse velocity of
money).
a) Use the PPP relationship to determine the expression for the equilibrium nominal exchange
rate as a function of all exogenous variables.
b) Suppose that a positive world shock increases long-run output in the two countries, with
1¤ ¡0¤
0
 1¡
, i.e. output increases more in the foreign country than in the domestic country.
0¤
0
How does the nominal exchange rate react to this shock?
Exercise 2
The Mundell-Fleming model. Use the  ¡  model to determine how a fall in the world
interest rate will a¤ect domestic output under …xed and ‡oating exchange rate regimes and high
(but imperfect) capital mobility.
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