Reference no: EM131159554
The Open Economy Consider the following open-economy IS-LM model. Suppose that foreign income is Y* = 1 and that both foreign and domestic prices are fixed at 1 (P = P* = 1). This implies that the real exchange rate is equal to the nominal exchange rate ( = E). Furthermore, assume that the 1 expected nominal exchange rate is equal to the foreign rate of return (E^e = 1+i* ). Finally, assume that the domestic money supply is equal to one (M^S = 1).
Consumption: C = 2 + 0.75YD
Investment: I = 0.2Y − 0.25i
Government expenditure: G = 2
Taxes: T = 4
Exports: X = 0.75Y* − 0.2
Imports: Im = 0.75Y + 0.25
Money demand: (M^d)/P = Y − i
1. Using the uncovered interest parity condition, write the nominal exchange rate as a function of the domestic interest rate.
2. Using the LM relationship and the uncovered interest parity condition above, express the nominal exchange rate as a function of domestic output.
3. Using your answers above, solve for the equilibrium domestic output. Show your work. [HINT: this will be a number.]
4. Solve for the equilibrium domestic interest rate and the equilibrium exchange rate. Show your work.
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