q4

Question 3 (12 marks) (a) (b) (C) Briefly explain what the law of one price is and what is its role in nominal and real exchange rate determination in the long run. (3 marks) Analyse the effects of an increase in the foreign interest rate lasting for one period using the open economy AS/AD model of the textbook. Assume that initially that domestic real output is on trend and both domestic and foreign real interest rates are equal to marginal product of capital. Also assume that inflation is at its target rate. Use a graph in you answer. (5 marks) Zootopia is a country with free financial flows which experiences frequent recessions. The governor of Zootopian central bank is deciding whether to introduce exchange rate targeting (i.e. the fixed exchange rate) or inflation targeting. You are hired as an economic expert to provide advice about this choice. What your advice would be? (4 marks)