2. This question considers the relationship between the Indian rupee (Rs) and the euro (e). Let India be "Home" and the European Monetary Union be "Foreign". Let the exchange rate be defined as rupees per euro, ERs/e. Assume, for simplicity, that European money supply, M , liquidity preferences L , price level P , nominal and real interest rates, i and r , and output, Y , are fixed throughout at the same constant levels; for India, the real interest rate, r, and liquidity preferences, L, are fixed throughout at the same constant level. All other variables - M, P, Y , i, Ee , E - are assumed to be steady and at constant levels in the "old" and "new" long run, but not necessarily at the same level. Further assume that the Indian price level is fixed ("sticky") in the short run. Clearly label your graphs. On all graphs, label the initial equilibrium point A. Suppose that technological progress leads to a permanent increase in India's real output/income Y . (a) With the help of the appropriate equilibrium conditions for the money market and the foreign exchange market, describe (in complete sentences) how and why (or why not) India's nominal interest rate, iLR, its price level, PLR, and its spot exchange rate, ELR, change in the long run [short run and transition period analysis to follow in parts (c) and (e)]. [Note: Full credit will only be given if you use the appropriate equilibrium conditions combined with economic reasoning to describe what is going on here. There will be no (partial) credit for any diagrams here.] Page 5 (b) Use the (linked) money market and foreign exchange (FX) market diagrams to illustrate how a permanent increase in India's real income affects the money and FX markets in the long run only. Label the long-run equilibrium point C. (c) With the help of the appropriate equilibrium conditions for the money market and the foreign exchange market, describe (in complete sentences) why and how (or why not) India's price level, PSR, its nominal interest rate, iSR, and its current spot exchange rate, ESR, and its (expected) future spot exchange rate, Ee , change in the short run . [Note: Again, full credit will only be given if you use the appropriate equilibrium conditions combined with economic reasoning to describe what is going on here. There will be no (partial) credit for any diagrams here.] Page 6 (d) Use the (linked) money market and foreign exchange (FX) market diagrams to illustrate how a permanent increase in India's real output affects the money and FX markets in the short run only (also using what you know from your answer above for the long run). Label the short-run equilibrium point B. (e) Given your answers in parts (a) and (c), describe (in complete sentences) with the help of the appropriate equilibrium conditions for the money market and the foreign exchange market, why and how (or why not) India's price level, P, its nominal interest rate, i, and its spot exchange rate, E, change during the transition/adjustment period from the short-run equilibrium to the long-run equilibrium. [Note: Again, full credit will only be given if you use the appropriate equilibrium conditions combined with economic reasoning to describe what is going on here. There will be no (partial) credit for any diagrams here.] Page 7 (f) Use the (linked) money market and foreign exchange (FX) market diagrams to illustrate how a permanent increase in India's real output affects the money and FX markets in the transition/adjustment period (using what you know from your earlier answers). Indicate the adjustment process with arrows. (g) Explain (very briefly) whether and how overshooting of the exchange rate does (or does not) apply to this situation.