We can express a linear approximation to the interest parity condition (accurate for small exchange rate changes) as: R = R* + (E^e - E)/E^e. Adding this to the model of problems 14 and 19, solve for Y as a function of G. What is the government spending multiplier for temporary changes in G (those that do not alter E^e)? How does your answer depend on the parameters a, b, and d, and why?

Data From Problem 14

Consider the following linear version of the AA-DD model in the text: Consumption is given by C = (1 - s)Y and the current account balance is given by CA = aE - mY. (In macroeconomics textbooks, s is sometimes referred to as the marginal propensity to save and m is called the marginal propensity to import.) Then the condition of equilibrium in the goods market is Y = C + I + G + CA = (1 - s)Y + I + G + aE - mY. We will write the condition of money market equilibrium as M^s/P = bY - dR. On the assumption that the central bank can hold both the interest rate R and the exchange rate E constant, and assuming that investment I also is constant, what is the effect of an increase in government spending G on output Y? (This number is often called the open-economy government spending multiplier, but as you can see it is relevant only under strict conditions.) Explain your result intuitively.