Suppose that the price level relevant for money demand includes the price of imported goods and that the price of imported goods depends on the exchange rate. That is, the money market is described by
M/P = L(r , Y),
Where
P = λPd + (1 − λ)Pf/e.
The parameter λ is the share of domestic goods in the price index P. Assume that the price of domestic goods Pd and the price of foreign goods measured in foreign currency Pf are fixed.
a. Suppose we graph the LM* curve for given values of Pd and Pf (instead of the usual P). Is this LM* curve still vertical? Explain.
b. What is the effect of expansionary fiscal policy under floating exchange rates in this model? Explain. Contrast with the standard Mundell–Fleming model.
c. Suppose that political instability increases the country risk premium and, thereby, the interest rate. What is the effect on the exchange rate, the price level, and aggregate income in this model? Contrast with the standard Mundell–Fleming model. This question anticipates part of what is covered in the appendix of this chapter.