In our model, we assumed that net exports could be specified as follows:

= + ( )

However, we know that when the central bank lowers interest rates, the return on domestic assets falls relative to foreign assets. As a result, the value of domestic assets relative to other currency assets falls, and the domestic currency depreciates. The lower value of the domestic currency makes domestic goods cheaper than foreign goods, thereby leading to expenditure switching and a rise in net exports.

Thus, we should include interest rate as one of the determinants in the net export function (similar to the way we introduce interest rate in the consumption and the investment functions).

Question One:

Explain how the effectiveness of contractionary monetary policy (d < 0) and

Fiscal policy (d < 0) depends on the magnitude of the response of NX to changes in r or dNX/dr. Make sure to provide your answer with the relevant graphs, mathematical equations, and economic interpretation.