This problem deals with the nominal exchange rate between the Canadian dollar and the US dollar. Let ECAD/USD be the nominal exchange rate between the Canadian dollar and the USD and assume that PUS and YUS are given. Suppose there is a permanent INCREASE in the level of income in Canada (an increase in YCAD). Hint: This will affect the Canadian real demand for money.

2.a) (14 points) Use the Monetary Model to Exchange Rates to explain how this permanent INCREASE in YCAD affects the price level in Canada (PCAD) in the long run and the nominal exchange rate in the long run (EeCAD/USD). Use equations to support your answer and explain why the variables change and the economic intuition behind those changes. Hint: A key equation here is the fundamental equation of the monetary model to exchange rate.

2.b) (16 points) How this permanent INCREASE in YCAD affects the interest rate, the spot exchange (ECAD/USD), the real exchange rate, and the price level in Canada (PCAD) in the SHORT-RUN. Use equations and a diagram of the foreign exchange market and the Canadian money market to support your answer. Explain why the variables change and the economic intuition behind those changes.