Question

Consider an open economy with flexible exchange rates. Let UIP stand for the uncovered

interest parity condition.

a. In an IS-LM-UIP diagram, show the effect of an increase in foreign output, Y*, on domestic

output (Y) and the exchange rate (E), when the domestic central bank leaves the policy

interest rate unchanged. Explain in words.

b. In an IS-LM-UIP diagram, show the effect of an increase in the foreign interest rate, i*, on

domestic output (Y) and the exchange rate (E), when the domestic central bank leaves the

policy interest rate unchanged. Explain in words.

Answer 1

a)

Rise in foreign output will imply that foreigners will demand more imports so our exports will increase. This will move the IS bend to one side. Presently observe that as IS movements to one side, there will be an expansion in the household financing cost. Loan fee rises.

This makes remote capital pour in which will build the interest for residential money as outside speculators will put resources into securities designated by home cash. Increased demand for home currency implies currency appreciation and so there is an upward movement along the UIP curve.

b)

Higher outside loan fee, suggests bring down relative financing cost thus toward the starting, when there is no adjustment in the conversion scale, UIP curve shifts to the left. This causes exchange rate to fall at the initial domestic interest rate level. Depreciated currency will increase exports. This cause IS to shifts again. As IS movements to one side, this will be an expansion in the residential loan cost

A partial currency appreciation is likely to occur overtime and so there is an upward movement along the UIP curve.