Mundell-Fleming model.

Consider an open economy IS-LM model.

China's currency is

the "Chinese Yuan Renminbi (CNY)" and the USA's currency is the "US dollar (USD)".

China has a fixed exchange rate regime with respect to USD. The central bank of China

maintains a peg of 1 CNY=0

.

125 USD. The interest rate in the USA is 4

.

5%.

(a) What do the above facts imply about the interest rate in China? Explain. (1 point)

(b) Suppose that the USA experiences an increase in output

Y

*

.

With the help of a

diagram, explain the short-run effects of the increase in

Y

*

on the economy of China