Question: a. Solve the UIP condition for the current exchange rate, Et. b. Substitute the result from part (a) in the IS curve and con-

a. Solve the UIP condition for the current exchange rate, Et. b.

a. Solve the UIP condition for the current exchange rate, Et. b. Substitute the result from part (a) in the IS curve and con- struct the UIP diagram. As in the text, you may assume that P and P* are constant and equal to one. c. Suppose that as a result of a large trade deficit in the domestic economy, financial market participants believe that the domestic currency must depreciate in the future. Therefore, the expected exchange rate, E(+1, decreases. Show the effect of the decrease in the expected exchange rate in the IS-LM-UIP diagram. What are the effects on the exchange rate and the trade balance? (Hint: In analyzing the effect on the trade balance, remember why the IS curve shifted in the first place.) d. Now suppose that the relative demand for domestic assets, x, increases. As a benchmark, suppose that the increase in x is exactly enough to return the IS curve to its original position, before the decrease in the expected exchange rate. Show the combined effects of the decrease in E+1 and the increase in x in your IS-LM-UIP diagram. What are the ultimate effects on the exchange rate and the trade balance? e. Based on your analysis, is it possible that an increase in demand for U.S. assets could prevent the dollar from depre- ciating? Is it possible that an increase in demand for U.S. assets could worsen the U.S. trade balance? Explain your answers.

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