Assume we are in a standard IS-LM-UIP economy.
A. Suppose that there is a shock in the domestic country that increases the risk premium. What happens to the domestic economy in the short run? In your answer make sure to include a description of the impact on interest rates, GDP, and the composition of output.
B. Will the domestic risk premium shock impact the foreign economy? If so, how? That is, describe the channel(s) by which a domestic risk premium shock may impact the foreign economy.
C. Next, suppose that there is a shock in the foreign economy that increases the risk premium in that country. Does this foreign risk premium shock impact the domestic country? If so, describe what this shock does to the composition of output in the domestic economy.