# Penalties for late lodgement

ECF2721 Assignment #2

(Total = 36 marks)

• Be sure to write down all steps for your answer.

• Penalties for late lodgement:

A late assignment, that is assignments submitted after the due date and where no extension has been granted, will be accepted, but in fairness to students who present their work on time, a penalty will be levied. A penalty of 10% of the total mark allocated to this assessment will be deducted for each day that it is late (including weekend). Please note that this policy applies to this unit only; other lecturers may take a different approach.

• Assessment coversheet:

Work submitted for assessment MUST be accompanied by a completed and signed assignment coversheet, available in Moodle. NO assignment will be accepted or marked if it is not accompanied by a signed Assignment cover sheet.

QUESTIONS:

Use the money market with the general monetary model and foreign exchange (FX) market to answer the following questions. The questions consider the relationship between the U.K. pound (£) and the Australian dollar ($). Let the exchange rate be defined as Australian dollars per pound, E$/£. In the U.K., the real income (Y£) is 2.00 trill., the money supply (M£) is £1.00 trill., the price level (P£) is £1.00, and the nominal interest rate (i£) is 4.00% per annum. In Australia, the real income (Y$) is 1.00 trill., the money supply (M$) is AU$0.75 trill., the price level (P$) is AU$1.50, and the nominal interest rate (i$) is 4.00% per annum. These two countries have maintained these long-run levels. Note that the uncovered interest parity holds all the time and the purchasing power parity holds only in the long-run. Assume that the new long-run levels are achieved within 1 year from any permanent changes in the economies.

1. Now, consider time T when the U.K. real income increases permanently by 10% unexpectedly so that the new real income in the U.K. becomes Y£ = 2.2 trill. With the new real income, the interest rate in the U.K. increased to 6% per annum today. Assume that Australia and the U.K. use the floating exchange rate system.

(a) Calculate the U.K. price level in 1 year (the new long-run price level in the U.K. at T+1), Pe£.

[2 marks]

(b) Calculate the expected exchange rate in 1 year (the new long-run exchange rate at T+1), Ee$/£ (round to three decimal places). [2marks]

(c) Calculate the exchange rate today, E$/£ (round to three decimal places). [4 marks]

(d) Calculate the real exchange rate, q$/£, today. [2 marks] [2 marks]

(e) Based on the half-life of the deviation from PPP, calculate the expected real exchange rate 4 years from today (T+4), qe $/£,4 (round to 4 decimal places). [4 marks]

2

(f) Using the money market for Australia and the FX market diagrams below (replicate them in your answer paper), illustrate how this change (the permanent increase in real income in the UK) affects the money market for Australia and FX markets. Label your short-run equilibrium point as B and your long-run equilibrium point as C in both diagrams. Be sure to use the Australian money market and the exchange rate defined as AU$ per US$, E$/£. Also be sure to label all curves and equilibrium levels (including the values of interest rates and exchange rates) in the diagrams to get full marks. [6 marks]

(g) Based on your answers to (b) and (c), using time series diagrams below, illustrate how the exchange rate, E$/£ changes over time in response to the permanent increase in the U.K. real income. Be sure to (i) label all axis, (ii) draw vertical dashed lines for time T and T+1 year, (iii) draw horizontal dashed lines for the initial long-run equilibrium as shown in the diagrams below to get full marks. [4 marks]

2. Now assume that Australian dollar is pegged to the UK pound with the exchange rate of EA/U = 1.5. The Reserve Bank of Australia (RBA) maintain this exchange rate all the time.

MS1

A

MD1

i$

4%

M1/P1

DR1

A

FR1

Returns

(in $)

4%

1.5

M$/P$

E$/£

i£

E$/£

T

T

Time

Time

i1=4%

E1=1.5

T+1 year

T+1 year

3

(A) What should be the interest rate in Australia today, i$, to maintain the par value of the exchange rate at AU$1.5 per pound (£)? Explain the reason. [4 marks]

(B) Should the RBA raise or reduce the money supply in Australia today to maintain the par value of the exchange rate at AU$1.5 per pound (£)? Explain the reason,. [4 marks]

(C) What should be the Australian money supply in the long-run to maintain the par value of the exchange rate at $1.5 per £1? Explain the reason. [4 marks]

Hint: Use the money monetary model to solve for M

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