Q26. Consider a small open economy with a floating exchange rate which can be described in the short run by the standard textbook Mundell-Fleming model and where the Marshall-Lerner condition holds. The three equations below describe the Mundell-Fleming model. [IS] Y = C(Y - T, Ye - Te, i - Te, A) + I (i - me, ye, K) + G + NX (@, Y*, Y), [LM] P = v (1) [IP] 1tix = (1ti). The relationship between inflation and output gap in the economy is given by the Phillips curve: [PC] . It = Te + Bin + z, E(z) = 0. I Suppose the central bank targets inflation which is initially at the target level. a. Use the IP-IS-LM-PC diagram to illustrate the model's prediction regarding the level of domestic interest rate following an increase in the foreign interest rate. Clearly label the axes and curves. [4 marks] b. Provide an intuitive explanation for the changes shown on your diagram. [3 marks] c. Outline the motivation and main findings of Edwards (2015) regarding the independence of monetary policy under flexible exchange rates. [3 marks]