Use the combined (side-by-side) IS-LM-FX diagram to answer this question. Clearly label the figures: axes, equilibrium points, levels of variables. Explain the graphs in words.

Assume the home central bank responds by using monetary policy to stabilize output Y, and assume that the exchange rate is floating.

For the following situations, use the IS/LM/FX model to illustrate the effects of the shock and policy response combined. For each case, state the effect of the shock and policy response combined on the following variables (increase, decrease, no change, or ambiguous): Y, i, E, C, I, TB.

1) Shock: The level of foreign income increases (Y* rises).

1a. IS-LM diagram FX market diagram

(side-by-side graphs)

1b. Explanations and effects of the shock and policy response combined:

2) Shock: The foreign central bank lowers its interest rate (i* falls).

2a. IS-LM diagram FX market diagram

(side-by-side graphs)

2b. Explanations and effects of the shock and policy response combined: