Exercise Set 14
MONEY, INTEREST RATES AND EXCHANGE RATES

I. Objectives

1. To obtain the equilibrium interest rate
2. To explain changes in interest rates and exchange rates.
   

II. Data

• The equation for money demand is:
  (1)         M^d = P(2 - 10r + 0.04Y),
  where M^d is nominal money demand, P is the price level, and Y is real GDP.
  
• The equation for money supply is:
  (2)         M^s = M,
  where M is the nominal money supply (fixed by the Fed).
  
• For given values of Y, P and M, obtain the equilibrium interest rate. 
• Click on Gimme Rates! to confirm.
  
  

M =

P =

Y =

r =

III. Questions

1. From equation (1), we observe that, ceteris paribus, money demand will increase if:
   
   1. GDP [ increases | decreases ].
   2. The price level [ increases | decreases ].
   3. The interest rate [ increases | decreases ].
2. Suppose the money supply is 400, the price level is 200, and real GDP is 3000 .
   1. Write the equation signifying equilibrium in the money market.
   2. Compute the equilibrium interest rate.
   3. Provide a sketch of the money market. Indicate the eqbm value of r on the graph.
3. In each case below, describe the effect on the equilibrium interest rate and provide the corresponding sketches:
   1. The central bank increases money supply by 10%.
   2. The country's GDP falls by 5%.
   3. The price level rises by 20%.
4. Consider the relationship between interest rates and exchange rates. 
1. An increase in domestic interest rates, ceteris paribus, will lead to capital [ inflows into / outflows from ] the country, causing its currency to [ appreciate / depreciate ]. Explain.
   
2. Suppose the Fed buys government securities in an open-market operation. Ceteris paribus, what are the effects of the Fed's policy on: (i) Money supply? (ii) Interest rates? (iii) The value of the dollar in the foreign-exchange market?