3. This question uses the general monetary model, where real money demand is inversely related to the nominal interest rate. Consider two countries, Japan and South Korea, where the currencies used are the Japanese yen and the Korean won, respectively. In 1996, Japan experienced relatively slow output growth (2%), while Korea had relatively robust output growth (7%). Suppose the Bank of Japan (Japans central bank) allowed the money supply to grow by 3% each year, while the Bank of Korea (South Koreas central bank) chose to maintain slightly higher money supply growth of 5% per year. In addition, bank deposits in Japan paid a nominal interest rate of iJ = 5%. You may further assume that real interest rates were equalized across these two countries.

You will find it easiest to treat Korea as the home country and Japan as the foreign country.

(d) How does the change in the nominal interest rate in part (c) affect the price level in Korea and the won-yen exchange rate, respectively, at the time of the re-unification shock? Explain briefly with the help of the respective equilibrium conditions for these two variables.