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Prediction Problem I (This is adapted from Question 5 in Chapter 7 of the text.)    ...

  1. Prediction Problem I (This is adapted from Question 5 in Chapter 7 of the text.)

    Suppose that there is an increase in foreign income(?∗). Assume that that the exchange rate is flexible.

  1. Predict how this would affect domestic income, domestic interest rates, the exchange rate, and the domestic trade balance.
  2. Suppose the Fed decides it wants to respond to this shock by using monetary policy to make income return to its initial value. Depict this policy. Predict how it would affect interest rates, the exchange rate, and the trade balance.
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