Return to problem 14 and notice that, to complete the model described there, we must add the interest parity conditions. Observe also that if Yf is the fullemployment output level, then the long-run expected exchange rate, Ee, satisfies the equation: Yf = 1aEe + I + G2 > 1s + m2. (We are again taking investment I as given.) Using these equations, demonstrate algebraically that if the economy starts at full employment with R = R*, an increase in G has no effect on output.

What is the effect on the exchange rate? How does the exchange rate change depend on

a, and why?