Equilibrium exchange rate and aggregate income in model

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Suppose that the price level relevant for money demand includes the price of imported goods, which in turn depends on the exchange rate. That is, the money market is described by M/P = L(r, Y ), where P = λPd + (1 − λ)(Pf/e). Here, Pd is the price of domestic goods in domestic currency and Pf is the price of foreign goods in foreign currency. Thus, Pf/e is the price of foreign goods in domestic currency. The parameter λ ∈ (0, 1] is the share of domestic goods in the price index P. Assume the Pd and Pf are sticky in the short-run. (a) Graph the LM∗ curve on Y − e plane. (b) What is the effect of expansionary fiscal policy under floating exchange rates in this model? How is it different from the benchmark Mundell-Fleming model? (c) Suppose that political instability increases the country risk premium θ so that r = r∗+θ. What is the effect on the equilibrium exchange rate and aggregate income in this model? How is it different from the benchmark Mundell-Fleming model?

Reference no: EM131103644

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