Question: Initially, both Home and Foreign are in their long-run equilibrium. The annual monetary growth rates for Home and Foreign are 3% and 4% respectively. The

Initially, both Home and Foreign are in their long-run equilibrium. The annual monetary growth rates for Home and Foreign are 3% and 4% respectively. The foreign output growth rate is 3%, which is 1-percentage point higher than that of Home's. In addition, the velocity of money is held constant in both countries. At T0, the central bank of Home adopts an inflation target of 2%. Use the monetary approach for the case of ongoing inflation to answer the following questions:

What monetary growth rate (% in MS) should the central bank of Home set at T0?
What is the rate of change in exchange rate (% in E) after T0? Is domestic currency expected to appreciate or depreciate after T0?

Explain and support your answer with the diagrams for the time paths of MS, R, P and E. (You must include numbers in your written and graphical explanations.)

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