A2. Imagine that the following events occurred in the period between 2004 and 2008. EU adopted new trade restrictions (such as higher tariffs) on Chinese products and reduced the annual rate of growth of their money supply from 5% to 3%.

Over the same period of time, Chinese trade policies and the Chinese money supply remained stable.

Consider these changes in a long-run framework with flexible prices (i.e. PPP based theories with the real exchange rate extension apply). How do you expect the real & nominal exchange rates between the EU and China to be affected by these events, i.e. how would they change over this period? Explain using the relevant model, graphically (e.g. time paths of relevant variables) and verbally.

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