Question

4.* NOT To BE SUBMITTED (BUT GOOD PRACTICE FOR MIDTERM 1) Slightly modified version of Feenstra and Taylor (2018), International Macroeconomics, Ch.3, question 8. This question uses the general (long-run) monetary model, where money demand is inversely related to the nominal interest rate Consider two countries, Japan (J) and Korea (K), where the currencies used are the Japanese yen (JPY) and the Korean won (KRW). In 1996, Japan experienced relatively slow output growth (1%), while Korea had relatively robust output growth (6%). Suppose the Bank of Japan (Japan's central bank) allowed the money supply to grow by 3% each year, while the Bank of Korea (Korea's central bank) chose to maintain relatively high money growth of 14% per year. In addition, bank deposits in Japan paid 3% interest, i,-3% Note: You will find it easiest to treat Korea as the home country and Japan as the foreign country) (a) Compute the interest paid on Korean deposits, ik (b) Using the definition of the real interest rate (nominal interest rate adjusted for inflation), show that the real interest rate in Korea (rK) is equal to the real interest rate in Japan (rv) (i.e., show that real interest parity holds) (c) Suppose the Bank of Korea (permanently) increases the money growth rate from 14% to 17% and the inflation rate rises proportionally (one for one) with this increase. If the nominal interest rate in Japan remains unchanged, what happens to the interest rate paid on Korean deposits? Calculate and explain (d) Using time series diagrams, illustrate and describe how this increase in the money growth rate affects the money supply, MK; Korea's (nominal) interest rate iki prices, PK; real ; and nominal exchange rate RKRWIJPY over time. (Plot separate diagrams with the respective variable of interest on the vertical axis and time on the money supply horizontal axis. Indicate the time of the policy change and label it as to)

Answer 1

a) Let us assume the relative PPP holds. This implies that the the exchange rate depreciation equals the inflation differential

  

= 14% - 6% =8%

where   is the rate of growth of money supply and g_k is the rate of growth of output.

= 3% - 1% = 2%

Therefore 8% - 2% + 3% = 9%

where   3%

b)

= 3% - 2% = 1%

and similarly

= 9% - 8% = 1%

So real interest rate parity holds.

c) We know that the inflation rate in Korea will increase to 11% . We also know that the real interest rate will remain unchanged. Therefore,  

1% + 11%= 12%

Interest rate paid on Korean deposits increases.