At present, inflation is lower than the inflation target and the national bank has communicated its intention to keep the interest rate at its current low level in order to bring inflation up against the target. At the same time, the latest budget bills entail an expansive fiscal policy.

a) Use the IS-LM model for an open economy to analyze what happens to GDP, the interest rate and the exchange rate.

b) Now assume that inflation is now rising and that the national bank no longer considers that the interest rate needs to be kept unchanged. What happens to GDP, interest rates and exchange rates then?