This question considers how the FX market will respond to changes in monetary policy. For these questions, define the exchange rate as Korean won per Japanese yen, EWON/¥. Use the FX and money market diagrams to answer the following questions. On all graphs, label the initial equilibrium point A.
a. Suppose the Bank of Korea permanently decreases its money supply. Illustrate the short-run (label the equilibrium point B) and long-run effects (label the equilibrium point C) of this policy.
b. Now, suppose the Bank of Korea announces it plans to permanently decrease its money supply but doesn’t actually implement this policy. How will this affect the FX market in the short run if investors believe the Bank of Korea’s announcement?
c. Finally, suppose the Bank of Korea permanently decreases its money supply but this change is not anticipated. When the Bank of Korea implements this policy, how will this affect the FX market in the short run?
d. Using your previous answers, evaluate the following statements:
i. If a country wants to increase the value of its currency, it can do so (temporarily) without raising domestic interest rates.
ii. The central bank can reduce both the domestic price level and the value of its currency in the long run.
iii. The most effective way to increase the value of a currency is through surprising investors.