Q9. Consider a small open economy of the New Oil City (NOC) that can be described by the standard textbook Mundell-Fleming model where the Marshall-Lerner condition holds. [ IS ] : Y = C ( Y - T, Ye - Te, i - me, A) + I (i - me, ye, K) + G + NX (@, Y", x), [LM]: - = V(O' [Phillips Curve]: It = ne + B (x - 1) ; B > O, [IP]: 1 + i* = (1 + i). Note that Y*, P*, and i denote output, price level, and the nominal interest rate in the rest of world (ROW), respectively. We also assume that the NOC allows free cross-border capital flows. Hence, the interest rate parity (IP) equation holds true. a) Assume that the NOC is hit by a small earthquake that temporarily reduces its natural output level Y" but keeps its capital stock K intact. What would happen to the Phillips curve? What would happen to the inflation rate it (or the price level P) in the NOC if the actual output level Y remains unchanged? (Hint: for simplicity, assume that the expected future variables such as Y, T, and e will not be affected by the earthquake.) [3 marks] b) Following the earthquake as described in part a), what would happen to the net export NX, the output level Y, the nominal interest rate i, and the nominal exchange rate e in the NOC, if the central bank keeps the money supply M unchanged? Use an IS-LM-IP diagram to answer the question. (Hint: you can start thinking what would happen to the real exchange rate ep / P* based on what you've derived in part a).) [4 marks] c) Following the earthquake as described in part a), what should the central bank do if the NOC wants to defend its nominal exchange rate e? Use an IS-LM-IP diagram to illustrate your answer. [3 marks]