Consider an open economy with flexible exchange rates. Let UIP stand for the uncovered interest parity condition.
a. In an IS-LM–UIP diagram, show the effect of an increase in foreign output, Y*, on domestic output (Y) and the exchange rate (E), when the domestic central bank leaves the policy interest rate unchanged. Explain in words.
b. In an IS-LM–UIP diagram, show the effect of an increase in the foreign interest rate, i*, on domestic output (Y) and the exchange rate (E), when the domestic central bank leaves the policy interest rate unchanged. Explain in words.