2. A small open economy with perfect capital mobility is characterized by the following equations: 𝑀𝑡 =3

[answerhappygod]

2. A small open economy with perfect capital mobility is
characterized by the following equations:
𝑀𝑡 =3𝑌−40𝑖 𝑃𝑡
𝑖𝑡 = 𝑖∗ − 𝑆𝑡+1−𝑆𝑡 𝑆𝑡
𝜎 = 𝑆𝑃 𝑃∗
Assume 𝑀𝑡 = 60, 𝑌 = 11, 𝑃∗ =
6 and 𝑖∗ = 0.075. In the long run, purchasing power
parity holds so that 𝜎 = 1 .
a) Draw and explain the MM and the PPP curves (30%)
b) What is the long run equilibrium? (20%)
Suppose we are at this long run equilibrium but
now 𝑀𝑡 increases by 30 to 90.
c) What is the new long run equilibrium? Explain your answer
using a diagram. (20%)
d) What happens to the nominal exchange rate 𝑆𝑡in the short
run? Draw a diagram and explain what will happen. (30%)