Throughout this question, assume that domestic and foreign inflation and expected inflation are zero and that the real exchange rate equals the nominal exchange rate.Assuming, to begin with, that the exchange rate is flexible, use an open economy IS-LM model to explain:

Question parts(type the answers in the box provided using the labels (a), (b), (c), (d), (e), (f).

(a) (3 marks)The effects of contractionary domestic monetary policy in the form of an increase in the domestic interest rate i on 1) domestic output. 2) domestic interest rates, 3) exchange rate and 4) net exports.

(b) (2 marks)The effects of expansionary domestic fiscal policy, in the form of an increase in domestic government spending G (assuming no response by the domestic central bank) on 1) domestic output. 2) domestic interest rates, 3) exchange rate and 4) net exports.

(c) (2 marks)The effects of contractionary foreign fiscal policy, in the form of a decrease in foreign government spending G* (again assuming no response by the domestic central bank) on 1) domestic output. 2) domestic interest rates, 3) exchange rate and 4) net exports.

Now suppose the exchange rate is fixed, not flexible and suppose the domestic output is below its natural level.

(d) (1 mark)Is it possible to engage in expansionary domestic monetary policy to increase output? Explain.

(e) (1 mark)Should the government engage in a one-time devaluation to increase output? What are the effects on 1) domestic output. 2) domestic interest rates, and 3) net exports following a devaluation.

(f) (1 mark)What will happen to the real exchange rate in the long-run if the government does nothing?