1. A Simple IS-LM-UIP Model (11 Points)

Let us consider a domestic open economy characterized by the following equations:

IS: = 1000 2000 20

LM: =

UIP: 1+i= (1+i*)E/e

where denotes the domestic output/income, stands for the domestic nominal interest rate in decimal form, represents the nominal policy rate chosen by the domestic central bank, stands for the foreign nominal interest rate in decimal form, stands for the actual nominal exchange rate defined as the price of the domestic currency in terms of the foreign currency and e stands for its expected future value.

a. Show that the equilibrium domestic output/income is a function of , and e. Explain how each of these three variables affect the equilibrium domestic output/income. (8 Points)

b. Let us consider that the domestic nominal interest is equal to 10% and the foreign interest is equal to 0%. Compute the equilibrium domestic output/income, the nominal exchange rate and the expected rate of appreciation of the domestic currency if e =1. (3 Points)