2. Consider an economy that suffers a fall in business confidence (which tends toreduce investment). Let UIP stand for the uncovered interest parity condition.a. Suppose the economy has a flexible exchange rate. In an IS – LM –UIP diagram,show the short-run effect of the fall in business confidence on output, the interest rate,and the exchange rate. How does the change in the exchange rate, by itself, tend toaffect output? Does the change in the exchange rate dampen (make smaller) oramplify (make larger) the effect of the fall in business confidence on output?b. Suppose instead the economy has a fixed exchange rate. In anIS – LM –UIP diagram, show how the economy responds to the fall in businessconfidence. What must happen to the money supply in order to maintain the fixedexchange rate? How does the effect on output in this economy, with fixed exchangerates, compared to the effect you found for the economy for part (a), with flexibleexchange rates?

Answered: 2. Consider an economy that suffers a…

2. Consider an economy that suffers a fall in business confidence (which tends to reduce investment). Let UIP stand for the uncovered interest parity condition.

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Question

2. Consider an economy that suffers a fall in business confidence (which tends to
reduce investment). Let UIP stand for the uncovered interest parity condition.
a. Suppose the economy has a flexible exchange rate. In an IS – LM –UIP diagram,
show the short-run effect of the fall in business confidence on output, the interest rate,
and the exchange rate. How does the change in the exchange rate, by itself, tend to
affect output? Does the change in the exchange rate dampen (make smaller) or
amplify (make larger) the effect of the fall in business confidence on output?
b. Suppose instead the economy has a fixed exchange rate. In an
IS – LM –UIP diagram, show how the economy responds to the fall in business
confidence. What must happen to the money supply in order to maintain the fixed
exchange rate? How does the effect on output in this economy, with fixed exchange
rates, compared to the effect you found for the economy for part (a), with flexible
exchange rates?

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