Flexible exchange rates and foreign macroeconomic policy
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. 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. Explain in words.
c. Given the discussion of the effects of fiscal policy in this chapter, what effect is a foreign fiscal expansion likely to have on foreign output, Y *, and on the foreign interest rate, i *? Given the discussion of the effects of monetary policy in this chapter, what effect is a foreign monetary expansion likely to have on Y * and i *?
d. Given your answers to parts (a), (b), and (c), how does a foreign fiscal expansion affect domestic output? How does a foreign monetary expansion affect domestic output? (Hint: One of these policies has an ambiguous effect on output.)