Question

Consider an open economy operating under flexible exchange rates. Assuming that both the domestic and foreign prices are constant, the economy's short-run behavior can be described by the following IS, LM and interest-parity equations:
Y = C(Y-T)+I(Y,i)+G+NX(Y,Y*,E)

i = i (i equals to i bar)

E = ((1+i)/(1+i*))Ee
The notation is standard except for the policy interest rate which is denoted by i (Moodle doesn't have the over-bar). The expected exchange rate Ee, foreign output Y* and the foreign interest rate i* are taken to be exogenous. Suppose that initially NX=0.
Analyze the effects of an increase in the domestic interest rate (i) on the exchange rate (E), net exports (NX), and the domestic output (Y), consumption (C) and investment (I). Briefly describe the economic intuition behind these effects.

Answer 1

So we have to analyze the effect of increase in the domestic interest rate on

1. Exchange rate (E)

2. Net exports (NX)

3. Dometic output (Y)

4. Consumption (C)

5. Investment (I)

We know that E = ((1+i)/(1+i*)) Ee

So an increase in dometic interest rate would sure lead to increase in exchange rate i.e. E. This will cause depriciation of home currency.

Because of this hoe goods now become more cheaper in the global markets as compared to theirs. So they would buy our products thus for domestic country exports rise vis-a-vis imports. This leads to increase in net exports.

Because of increase in net exports through increase in interest rates dometic output also increases as net exports are a part of domestic income. Thus Y increase

As it is mentioned that consumption is a function of income i.e. C(Y-T) thus it would increase consumption too as there is a rise in disposable income.

Finally aas investment is also a function of income so a rise in income would definately increase investments.