Suppose that interest parity does not hold exactly, but that the true relationship is R = R* + (Ee - E)/E + , where

Suppose that interest parity does not hold exactly, but that the true relationship is R = R* + (Ee - E)/E + ρ, where ρ is a term measuring the differential riskiness of domestic versus foreign deposits. Suppose a permanent rise in domestic government spending, by creating the prospect of future government deficits, also raises, ρ that is, makes domestic currency deposits more risky. Evaluate the policy’s output effects in this situation.