3. (5.5 p.) Consider a small open economy with fixed prices and wages. The consumption and investment functions are: C =C, + c(Y-T); I = 1,- bi, where i is the domestic interest rate. Government spending and taxes are exogenously fixed at G = G, and T = T. Net exports are given by: NX = NX -mY+ ae, where e is the nominal exchange rate (defined as the domestic-currency price of foreign currency). Money-market equilibrium is represented by the equation: M/P=L, +kY- hi. Capital mobility is imperfect, and capital flows are given by the equation: CF=CF,+ f(i-i*), where i* is the foreign interest rate. Assume low degree of capital mobility. (a) Suppose that the domestic economy is increasingly perceived by foreign investors as a 'safe haven' for their wealth. Foreign investors thus want to purchase more domestic assets, so all else equal, capital inflows rise (the term CF0 increases). Assuming the economy has a flexible exchange rate, find the effects of these capital inflows on output, interest rate, nominal exchange rate, money supply, current account, and national saving using (i) graphical analysis and (ii) using algebraic analysis. (b) Find what difference a policy of fixing the exchange rate would make when faced with increased capital inflows. 3. (5.5 p.) Consider a small open economy with fixed prices and wages. The consumption and investment functions are: C =C, + c(Y-T); I = 1,- bi, where i is the domestic interest rate. Government spending and taxes are exogenously fixed at G = G, and T = T. Net exports are given by: NX = NX -mY+ ae, where e is the nominal exchange rate (defined as the domestic-currency price of foreign currency). Money-market equilibrium is represented by the equation: M/P=L, +kY- hi. Capital mobility is imperfect, and capital flows are given by the equation: CF=CF,+ f(i-i*), where i* is the foreign interest rate. Assume low degree of capital mobility. (a) Suppose that the domestic economy is increasingly perceived by foreign investors as a 'safe haven' for their wealth. Foreign investors thus want to purchase more domestic assets, so all else equal, capital inflows rise (the term CF0 increases). Assuming the economy has a flexible exchange rate, find the effects of these capital inflows on output, interest rate, nominal exchange rate, money supply, current account, and national saving using (i) graphical analysis and (ii) using algebraic analysis. (b) Find what difference a policy of fixing the exchange rate would make when faced with increased capital inflows