Exercise 4 Based on the Mundell
Fleming model, answer the following items:

a. How does a fall in international interest rates affect the real output in a small, open economy under a flexible exchange rate? What happens to the output in the case of a fixed exchange rate? Graphically illustrate both cases. Explain how your answer depends on the degree of capital mobility in the economy.

b. Assume there is perfect capital mobility and that this small, open economy operates on a fixed exchange rate regime. Assume that the government permanently raises its spending level. What are the impacts of this change in fiscal policy on the real output and on the current account for this economy? How does your answer to this item compare with the results that would be obtained in an intertemporal model similar to that seen in Chapter 4?