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QUESTION B4 Assume the domestic price level, P, inflationary expectations, πe,  and the expected nominal exchange rate,...

QUESTION B4

Assume the domestic price level, P, inflationary expectations, πe,  and the expected nominal exchange rate, Ee, are fixed in the short run; also assume that the Marshall-Lerner conditions hold.

Show diagrammatically and explain the impact, in the short run that a significant fall in international interest rates, i*, would have on the domestic interest rate, i, on the nominal exchange rate, E, on real GDP, Y, and on real private consumer expenditure, C (which is dependent on movements in both household disposable income and i), for an open economy that is operating:

(In answering this question, utilize the open economy IS-LM-UIP model and diagrams developed in the ECON 202 Course.)

(a)       A floating exchange rate regime

(b)       A fixed exchange rate regime  

(In answering this question, utilize the open economy IS-LM-UIP model and diagrams developed in the ECON 202 Course.)

(c)       Now suppose this small open economy suffers a recession and needs to achieve a real depreciation for the economy to recover. Explain how this is achieved over the medium term: (i) under a floating exchange rate and (ii) a fixed exchange rate.

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