# Problem Set 3 ```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 &curren; ) economy is given by the Cambridge quantity equation:
&frac12;
  =  
 &curren; =  &curren;  &curren; &curren;
&iexcl;
&cent;
where    &curren; is domestic (foreign) money demand,  ( &curren; ) is the domestic (foreign) price
level,  ( &curren; ) is real domestic (foreign) income and  (&curren; ) 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&curren; &iexcl;0&curren;
0
 1&iexcl;
, i.e. output increases more in the foreign country than in the domestic country.
0&curren;
0
How does the nominal exchange rate react to this shock?
Exercise 2
The Mundell-Fleming model. Use the  &iexcl;  model to determine how a fall in the world
interest rate will a&curren;ect domestic output under …xed and ‡oating exchange rate regimes and high
(but imperfect) capital mobility.
5
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