1) Describe how each of the following factors might explain why PPP is a better guide for exchange rate movements in the long run versus the short run: (i) transactions costs, (ii) nontraded goods, (iii) imperfect competition, (iv) price stickiness. As markets become increasingly integrated, do you suspect PPP will become a more useful guide in the future? Why or why not? 2) Consider two countries: Japan and South Korea. In 1996 Japan experienced relatively slow output growth (1%), whereas South Korea had relatively robust output growth (6%). Suppose the Bank of Japan allowed the money supply to grow by 2% each year, while the Bank of Korea chose to maintain relatively high money growth of 15% per year. In addition, the bank deposits in Japan pay a 3% interest rate, i = 3%. This question uses the general monetary model, where L is no longer assumed constant and money demand is inversely related to the nominal interest rate. You will find it easiest to treat South Korea as the home country and Japan as the foreign country. a. Compute the interest rate paid on South Korean won deposits. b. Using the definition of the real interest rate (nominal interest rate adjusted for inflation), show that the real interest rate in South Korea is equal to the real interest rate in Japan. c. Suppose the Bank of Korea decreases the money growth rate from 15% to 12% and the inflation rate falls proportionately (one for one) with this increase. If the nominal interest rate in Japan remains unchanged, what happens to the interest rate paid on Korean won deposits? d. Using time series diagrams, illustrate how this decrease in the money growth rate affects the money supply MK; South Korea's interest rate; prices P✓ ; real money supply; and Ewon/ over time. (Plot each variable on the vertical axis and time on the horizontal axis.)