1. Mundell-Fleming Model: We consider a small country that takes
foreign interest rate $i^*$ and output $Y^*$ as given. Also, price
level is fixed at 1 in both countries so that there is no
distinction between real and nominal variables.
Domestic Goods Market
Consumption function: $C = 10 + 0.5(Y - T)$
Taxation: $T = 20$
Investment: $I = 0.2Y - 500i$
Domestic Money Market
Government spending: $G = 50$
Net Exports: $NX = 0.4Y^* - 0.2Y - \frac{55}{S}$
Money demand: $M^d = 0.4Y - 550i$
Money supply: $M = 20$
The foreign interest rate is given as $i^* = 0.1$, and foreign output
is at $Y^* = 100$. Assume that the uncovered interest parity (UIP)
holds:
$S = \frac{1 + i^*}{1 + i}S^*$
Expected exchange rate is held fixed at $S^* = 1$.
Now the central bank decides to buy 4 units of bonds from the
market, assuming that people hold deposit only and banks keep
20% as reserve.
Calculate the new level of output as a result of the bond
buying, assuming that exchange rate is flexible and capital flow
is free. (If your solution for interest rate turns negative,
explain how that affects the solution for output when interest
rate has a zero lower bound).
