Suppose that the price level relevant for money demand includes the price of imp

Question

Suppose that the price level relevant for money demand includes the price of imported goods and that the price of imported goods depends on the exchange rate. That is, the money market is described by M P=L(r,Y) where P=PD +(1)PF /e The parameter is the share of domestic goods in the price index P. Assume that the price of domestic goods PD and the price of foreign goods measured in foreign currency PF are fixed.

Suppose that political instability increases the country risk premium and, thereby, the interest rate. What is the effect on the exchange rate, the price level, and aggregate income in this model? Contrast with the standard Mundell–Fleming model.

Explanation / Answer

According to the question, if there is political instability which increases the country risk premium and, thereby, the interest rate, exchange rate would experience appreciation in value due to increase in demand for currency. Price level would also experience a hike. Aggregate income would also increase as due to appreciation of exchange rate, more demand for currency would be there, there would be increase in exports and the production would also increase leading to increase in aggregate income.

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