Question: Question 1 Suppose there is a permanent increase in aggregate real money demand, for any given level of the nominal interest rate and output level.

Question 1 Suppose there is a permanent increase in aggregate real

Question 1 Suppose there is a permanent increase in aggregate real money demand, for any given level of the nominal interest rate and output level. Trace the short-run and long-run effects of the exchange rate, interest rate and price level. Does the nominal exchange rate overshoot or undershoot in the short-run? What is the mechanism behind the latter effect? How does your answer about the short-run behaviour of the exchange rate modify if, in addition to the permanent increase in real money demand, output falls in the short-run? Supplement your answer with a carefully explained diagrammatic analysis. (1500 word limit) (50 marks]

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