1. Assume an open economy IS-LM model, in which the economy is open to international financial flows, the uncovered interest parity condition holds, and we are analyzing a small open economy so the foreign interest rate is exogenous.

(a) Assume a flexible exchange rate regime and compare the effects of a fiscal expansion to a monetary expansion. Explain the impacts on Y, E and NX using the relevant graphs.

(b) What if the fiscal expansion is accompanied with central bank action to lower the interest rate? Show and explain on a new IS-LM graph.

(c) What might be the motivation of the central bank if it responds in this way?

2.Which bond should an investor choose:

Dollar-denominatedbondEuro-denominated bond

i_$=6%i= 8%

spot exchange rate = .90 euro/$1

expected future spot exchange rate = .96 euro/$1

Assume a 1-year time horizon.

Show all calculations. Also, explain in words.