Frovea's currency is called the fromark, and Olympia's currency is called the olymark. In the market in which fromarks and olymarks are traded for each other, the supply of and demand for fromarks are given by
Demand = 26,000 - 5,000e + 40,000( F O r - r ),
Supply = 19,500 + 8,000e - 40,000( F O r - r ).
The nominal exchange rate e is measured as olymarks per fromarks, and F r and O r are the real interest rates prevailing in Frovea and Olympia, respectively.
a. Initially, = = 0.10
F O r r , or 10 %. Find the market equilibrium value of the framark.
b. The Olympian central bank grows concerned about inflation and raises Olympia's real interest rate to 13 percent. What happens to the market equilibrium value of the fromarks?
c. Assume that the exchange rate is flexible and the Frovia does not change its real interest rate following the increase in Olypia's real interest rate. Is the action of the Olympian central bank likely to increase or reduce aggregates demand in Frovea? Discuss.