Demand for U.K. assets, the pound, and the trade deficit

This question explores how an increase in global demand for U.K. assets is likely to slow down the depreciation of the British pound. Here we modify the IS-LM-UIP framework (where UIP stands for uncovered interest rate parity) to analyze the effects of an increase in the demand for U.K. assets. Write the uncovered interest rate parity condition as:

(1 + it) = (1 + i*t)(Et/Eet + 1) - x

Where x represents factors affecting the relative demand for domestic assets. An increase in x means that investors are willing to hold domestic assets at a lower interest rate (given the foreign interest rate and the current and expected exchange rates).

a. Solve the UIP condition for the current exchange rate, Et.

b. Substitute the result from part a in the IS curve and construct the UIP diagram. As in the text you may assume that P and P* are constant and equal to one.

c. The British pound has a higher interest rate in comparison to the euro. According to the UIP condition, explain whether the expected rate of the pound (Eet + 1) is supposed to appreciate or depreciate in the future. What are the effects on output and net exports? How is this reflected in the IS-LM-UIP diagram?

d. Suppose that there are expectations that the expansionary monetary policy by the Bank of England will result in a permanent future increase in the money supply. If the prices of goods and services are fully flexible, do you expect the spot exchange rate to respond immediately?

e. What is the effect of an increase in the demand for domestic assets x? Do you expect that this increase will prevent the depreciation of the pound?