Assume a two-country world economy. The domestic country& the foreign one. Assume also that the real & financial and income variables of the two countries are defined as follows:

R= return on domestic currency deposits

R*= return on foreign currency deposits

E= spot exchange rate between domestic currency and foreign currency

E*= expected spot exchange rate

B = domestic country's bonds B*= foreign country's bonds P=price level in domestic country p*= price level in foreign country Y= income level in domestic country

Y*= income level in a foreign country

Md=L(y, R)= demand for money in domestic country

M/p=supply of real money in domestic country

p=foreign exchange market risk

By using the above information and assumptions you are required to answer the following questions:

A) Write down the foreign exchange market equilibrium condition between domestic and foreign currency exchange rate.

B) Assume that the domestic and foreign assets are perfect substitution, write down the foreign exchange market equilibrium condition if domestic exchange rate is flexible.

C) Assume also that the domestic and foreign assets are imperfect substitutability, write down the foreign exchange market equilibrium condition if domestic exchange rate is flexible.

D) Suppose the domestic country is holding R=7%, while the foreign country is holding R*=6%, and suppose the current exchange rate E is equal one $ per one pound. What does the market expect the exchange rate to be one year from now?

E) Based on the information given in (4) above what does the market expect the exchange rate to be one year from now, if domestic and foreign assets are imperfect substitution and exchange market risk is equal to .02? F) Assume also the foreign country is showing a sign of weakness, and the central bank of foreign country conducts open - market operation, in which it buys B* (foreign bonds). What this would do to R*? now, use the domestic country AA-DD model to assess the short-run effects on E &Y of the foreign country central bank's purchase of B*?