Suppose the Mundell-Fleming model (free capital mobility) with the following functions consumption, investment, net exports and currency demand:

C = 100 + 0,6Y

I = 20 - 10i

NX = 10 - 0,3Y + 0,5Y* + 4E

M^d/P = 10Y - 20i

Government consumption is G=50 and the real money supply is M/P = 10000. The external income is equal to Y *=1000 and the external interest rate is equal to i *=0.02.

Suppose that there is no expectation of exchange rate variation over time. The probability of default is equal to p for the domestic security, and zero for the foreign security. In this case, the uncovered interest rate implies that:

(1 + i) (1-p) = (1 + i *)

Suppose a flexible exchange rate regime. Initially p = 0. A political crisis then erupts, reducing confidence that the country will honor its debt commitments. As a consequence, p rises to 10%.

How much does this change in p cause a depreciation in the domestic currency?