1. Identify and discuss the factors that affect exchange rates in the long-run

Answer) There are a number of factors that have direct or indirect effects on the long run exchange rate. Some of these major factors are discussed below in detail:

-          Inflation Rates: Fluctuation in the rates of inflation also generate the effects on the exchange rate. Countries having the lower rate of inflation lead the market and earn appreciation in the exchange rate and currency value.

-          Interest Rates: With the increase in the interest rate currency rates of the country get changes that draw impact on the exchange rate of the country. Basically, interest rate also gets the effect on the inflation rate of the country as it goes up it causes to increase the interest rate also.

-          Government Debt: Government debt is the amount that we a considered as the borrowed amount of money from the foreign countries by the central government of the country. While it is considered as local or public debt also. Because of government debt inflation, and interest rate gets the change that draws impact on the exchange rate. While the increase in the government debt reduce foreign investment and causes to downfall the exchange rate.

-          Terms of Trade: The term trade presents how much transactions a country made for the import and export of goods and services in the international market. The currency value of the countries increases when the pay attention to the export more than the import. Terms of trade support the government in this matter to stable the export business of the country in the international market.

-          Political Stability and Performance: For better currency and exchange rate political factors also play the important role, particularly in the long run. Unstable and poor political condition of the country draws negative impact in the international market. While positive, stable and strong political condition of the country causes to increase the exchange rate.

-          Recession: In the situation of recession interest rates goes toward decline with continues ratio. As a result of this foreign investors feel less interest in investing in the foreign capital as they know it will generate less revenue for them because of the low rate of interest.

-          Speculation: Speculation also contributes to the exchange between countries. When an economic data shows that in near currency rate/value of the country ( in which any investor is eager to invest) will increase investor make investment rapidly to earn more in return on investment. Thus chances of increase in the currency value increase investment and exchange rate.

2.      Explain inflation targeting. What are the advantages and disadvantages of this type of monetary policy strategy?

Answer) Following are the five elements of inflation targeting:

-          Medium term target’s public announcement for the rate of inflation

-          The price stability commitment as the policy's long-term primary goal

-          Use of various variables in decision making regarding policy moves

-          Transparency increase about the strategy of policy with the public

-          Accountability increase by the central bank for attaining the policy goals.

The inflation targeting advantages include the clarity and simplicity of the numerical inflation rate target; there is increased central bank accountability; reduces the inflationary shocks’ effects.

The inflation targeting’s disadvantages: there is the delayed signal about the target’s achievement; the rigid rule could be led where the only and major focus is the inflation rate; if the inflation rate is the sole focus, larger fluctuations in output can occur.

3.      Explain and show graphically why continuous monetary growth is needed to generate inflation. Describe how the inflation process is generated.

Answer)

Aggregated demand get increases with the continuous monetary growth in an economy. As a result of this interest rate goes upward to increase. Economic factors other than the monetary growth cannot continuously increase the demand that is compulsory to generate the inflation. In the graph presented above the whole process is projected. According to the graph, the aggregated demand curve is continuously shifting towards the right and the aggregated supply curve is shifting towards the left side. While in the whole situation wages are continuously getting the adjustment.

4.      Using the aggregate demand-aggregate supply model, explain and demonstrate graphically the short-run and long-run effects of an increase in the money supply.

 Answer)

Monetary supply increase causes to increase the demand (AD). Therefore curve AD1 is shifting towards the AD2. Prices in the short run get increases with the increase in real output. While in the long run aggregated supply decreases and support the wages to get adjustment according to the supply. In the long run real output decreases continuously until to reach the natural output level. In the graph, prices are increased in long run.

5.      Assume that a fixed exchange rate is overvalued. Describe the situation of a speculative crisis against this currency.  What can the central bank do to defend the currency?  Why might the alternative of devaluation be preferable?

Answer) When a fixed exchange rate is overvalued and speculative crisis begins against the currency the expected depreciation on the fixed assets and domestic currency of a country increases substantially. Most of the time such situations are powered by the speculative attacks. In this attack overall demand for the assets (the domestic assets) goes towards decline. In such a situation, currency can be only defended through the contractionary monetary policy. Financial institutes as a central bank increase the interest rates to stabilize the currency value. While alternative of the devaluation is preferable as intervention and contractionary costs draw impacts on the economy of the country.