Open Economy IS-LM-FE with fixed exchange rates: Suppose that because the exchange rate kept fluctuating continuously, the government of the small open economy Kanata described in question 3 above decides to adopt a fixed nominal exchange rate. Assume that P = PF OR = 1 and that the value of the nominal exchange rate is set to enom = 80, so that it is initially equal to the real exchange rate e.
(a) What is the effect (in words) on the value of the currency in the short run if the money supplied is increased to M = 100? Explain with the aid of a diagram what the central bank must do to fix the nominal value of the currency.
(b) What do you conclude concerning the ability of the central bank to use monetary policy to pursue macroeconomic stabilization goals under a fixed exchange rate regime?
(c) Assume that the economy is initially at the general equilibrium given in part (b) of question 3 above, where P = 1, M = 80, and G = 20. What is the short run output that satisfies real interest rate parity of Kanata with the rest of the world (the one from part 3(b)) if G increases to 50? By how much must the nominal money supply M change to keep the value of the currency constant?
(d) With the aid of a diagram, explain how the economy returns to general equilibrium following the fiscal expansion.
(e) Compare, in your own words, the short-run effect of the fiscal expansion to that in the case of a country with a flexible exchange rate regime (no calculations necessary).