QUESTION 4. Short-Run Exchange Rate Determination a) Draw a diagram showing the short-run, market equilibrium determination of a bilateral nominal spot exchange rate in the market for bank deposits. Label your diagram carefully. b) Now suppose that the domestic central bank decides to raise the domestic short-run bond interest rate through open market operations. Graphically illustrate the short-run effect of the open market operations for the domestic currency market (currency supply equals currency demand in equilibrium), label, and explain your diagram. Also describe in words what the open market operation is that the central bank must conduct, and how exactly this open market operation accomplishes the desired increase in the short-run bond interest rate. c) Assume that because banks receive a higher interest rate on the bonds they hold as assets, they can offer a higher interest rate on deposits. Then combine your diagram of the domestic currency market in b) with your initial diagram of the determination of the spot exchange rate in a) and show the effect for the equilibrium exchange rate of the higher domestic bond and deposit interest rate. Describe in words how this exchange rate effect comes about. d) Whether deliberately or not, the central bank's contractionary monetary policy is likely to affect this country's trade balance in the short-run. Explain how the trade balance is affected and why. e) What would the goal(s) of a central bank be in raising the domestic interest rate through open market operations? Can you relate your answer to very recent Federal Reserve Bank policy in the United States? Does the effect that this policy has, theoretically, for the nominal exchange rate and trade balance in the short-run increase or decrease the likelihood of the central bank achieving its goal(s) in the short-run. [Hint: think about the goods market effects for demand and output, and the import price effects.]