2 Question 2
Consider a small open economy (SOE) with a floating exchange rate regime. Assume that the expecta-
tion about the future exchange rate is fixed. The economy can be summarised by the following system
of equations:
$Y = C(Y - T, Y^e - T^e, i - \pi^e, A) + I(Y^e, i - \pi^e, K) + G + NX \left(\frac{1 + i}{1 + i^*} \frac{e P}{P^*}, Y, Y^*\right)$
$\frac{M}{P} = \frac{Y}{V(i)}$
(2.1) Interpret the above equations and illustrate the model graphically. Explain how the domestic
nominal interest rate affects the domestic aggregate demand.
(2.2) Analyse mathematically and graphically the effects of an increase in the foreign nominal interest
rate ($i^*$) on the domestic GDP and on the nominal exchange rate.
• For the mathematical part, assume that the central bank controls the domestic nominal in-
terest rate.
• For the non-mathematical part, explain carefully the transmission mechanisms both when
the central bank controls the domestic nominal interest rate and when the central bank
controls the money supply.