Chapter 9. (Carlin and Soskice, 2015)

Problem 3: Assume you are in a small open economy with flexible exchange rates. The economy experiences a permanent positive demand shock.

a) Draw the PC - MR, the IS - RX and the AD - ERU diagrams to help explain the path back to medium-run equilibrium.

b) Draw a graph of the real exchange rate over time and give a brief explanation of its path.

c) How does the medium-run equilibrium vary from that which would occur in a closed economy subjected to the same shock?