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Q. Assume an economy is in a liquidity trap.
A. Write an equation expressing interest rate parity under a fixed exchange rate regime.
Answer: Liquidity trap entail R = 0. R = 0 = R* + (Ee - E)/E.
B. Assume Ee is fixed. Suppose that the central bank raises the domestic money supply so as to depreciate the currency temporarily (that is, to raise E currently but return the rate to Ee later). Show that E cannot be raised.
Answer: Ever since R = 0 the equation in part A the interest parity condition implies E = Ee / (1- R*) as Ee and R* are fixed E can't change.
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