Answer:
Explanation:
a) The quantity theory of money refers that money supply growth is equal to the increase in price plus output growth rate.
Thus, Inflation rate = Money Supply Growth - Output (GDP) Growth
Hence, Inflation in Home is computed as under:
= 12% - 6%
= 6%.
Inflation in Foreign is computed as under:
= 2% - 1%
= 1%.
Therefore, Inflation rate in Home and Foreign are 6% and 1% respectively.
b) The expected rate of depreciation refers to the decrease in the value of home currency relative to the foreign currency. It is computed by the difference of inflation rate between Home and Foreign currency.
Thus, Rate of depreciation = Inflation rate in Home - Inflation rate in Foreign.
Rate of depreciation:
= 6% - 1%
= 5%.
Therefore, the expected rate of depreciation in the Home currency relative to the Foreign currency is 5%.
c) New inflation rate in Home = New money supply growth - Output Growth
New inflation rate in Home country:
= 15% - 6%
= 9%.
Therefore, the new inflation rate in Home country is 9%.
(d) For keeping the exchange rate constant, the Central Bank of Home should lower its money growth rate. This can be computed exactly which money growth rate will keep the exchange rate fixed by using the fundamental equation for the simple monetary model as under:
(µH* - gH) = (µF - gF)
Putting the values given above and solving for µH*:
(µH* - 6%) = (2% - 1%)
µH* = 7%.
Therefore, if the Central Bank of Home country sets its money growth rate to 7%, then its exchange rate with Foreign Country will remain unchanged.
