3. This question is about the relationship between the won and the U.S. dollar. Suppose that with financial innovation in Korea, real money demand in Korea decreases. That is, for any given level of interest rate and output, real money demand falls.

a. Assume this change in Korean real money demand is temporary (the economy reverts back to the initial equilibrium in the long run). Using the foreign exchange/money market diagrams, illustrate how this change affects the money and foreign exchange markets. Label the initial equilibrium point 1, the short-run equilibrium point 2, and the long-run equilibrium point 3.

b. Assume this change in Korean real money demand is permanent. Using a new diagram, illustrate how this change affects the money and foreign exchange markets. Label the short-run equilibrium point 2 and the long-run equilibrium point 3.

c. Illustrate how each of the following variables changes over time in response to a permanent reduction in real money demand: nominal money supply Ms K, price level PK, real money supply Ms K/PK, Korean interest rate R, and the exchange rate E/$.