Question 5 (length guide: about 2 pages including graphs) Consider a small open economy with a flexible exchange rate. (a) Write down the IS relation, the LM relation and the interest parity relation and explain what they represent. Show them on a clearly labelled diagram(s). (5 marks) Use the Mundell-Fleming model to predict the effects on output, the nominal exchange rate, and the trade balance in each of the following cases: (b) A monetary expansion where the central bank raises the interest rate temporarily. (5 marks) (c) A temporary increase in consumer confidence where the central bank chooses to respond to any possible inflationary pressure (hint: see how the central bank would adjust its policy instrument). (5 marks)

Fig: 1