5. Consider and economy with a fixed exchange rate ( = fixed exchange rate parity). The exchange rate is defined as the price of the domestic currency in terms of the foreign currency. Suppose that at time (t-1) financial market participants believe that the government is committed to the fixed exchange rate. At time t, however, financial market participants become fearful that the government will devalue or allow the exchange rate to float (which would, everyone believes, lead to a currency depreciation).

(a)At time t, what happens to the expected exchange rate, E^e_(t+1)? Draw an IS-UIP diagram with UIP curves for time (t-1) and time t and explain why the UIP curve change at time t.

(b)Suppose that the government decides to maintain E_t= .What must happen to the interest rate in order to achieve this? What happens to output?

(c)Suppose that instead the government decides to devalue the currency, E_t= E^e_(t+1). What does this imply for the interest rate and output?

(D) How might expectations of a devaluation, even if they are unfounded, force a government to devalue? Why do we call such a devaluation a self-fulfilling exchange rate crisis?