Consider two countries, Japan and Korea. Suppose the Bank of Japan allows the money supply to grow by 1% each year, whereas the Bank of Korea maintains relatively high money growth of 6% per year. In both countries, assume that the domestic rate of inflation is equal to domestic money supply growth. Suppose bank deposits in Japan pay 3% annual interest (i. e R¥ = 3%). For the following questions, use the monetary model of the exchange rate.
(a) What is the inflation rate in Korea? In Japan?
(b) What is the expected rate of depreciation in the Korean won relative to the Japanese yen?
(c) Suppose the Bank of Korea increases the money growth rate from 12% to 15%. If nothing in Japan changes, what is the new inflation rate in Korea?
(d) Using time series diagrams, illustrate how this increase in the money growth rate affects the money supply, MK; Korea’s interest rate; prices, PK; real money supply; and Ewon/¥ over time. (Plot each variable on the vertical axis and time on the horizontal axis.)
(e) Suppose the Bank of Korea wants to maintain an exchange rate peg with the Japanese yen. What money growth rate would the Bank of Korea have tochoose to keep the value of the won fixed relative to the yen?
(f) Suppose the Bank of Korea sought to implement policy that would cause the Korean won to appreciate relative to the Japanese yen. What ranges of the money growth rate (assuming positive values) would allow the Bank of Korea to achieve this objective?