a. Generalise the model in Sections 3.7.1 and 3.7.2 to allow for i) an inflation risk premium, l, l* in each country’s money market and ii) a risk premium, r, in the UIRP relationship. Then show what conditions have to apply in this more general setting for (3.18) and (3.19) to be valid. Explain your conclusions.

b. What factors are likely to drive a wedge between real interest rates in different countries?