1. Assume the exchange rate is fixed (and expected to remain fixed). Using numbers and the ‘money supply-money demand and interest rate parity diagram’, explain how an increase in the U.S. interest rate from 3% to 7% affects the Mexican interest rate, foreign exchange reserves, and the money supply in the very short run. Hold domestic credit fixed. Also include the diagram that shows the flows in money and bonds. 

2. The exchange rate is fixed. Using the two-sector model, explain how an exogenous increase in the marginal product of labour in the traded sector affects domestic prices, wages, and the price level in the long run. Hold all other exogenous variables fixed. 

3. Fill in the blanks. Do not explain; just fill in the blanks (put your answers in the booklet). (a) The exchange rate is fixed today. If, all of sudden, investors expect a devaluation of the domestic currency in the near future (there is an exogenous increase in the expected future exchange rate), the domestic interest rate ________ and foreign exchange reserves _________ in the very short run. (b) In the two-sector model with a fixed exchange rate, an exogenous increase in the marginal product of labour in the non-traded sector causes the price of the non-traded good to _______ and the wage rate to _________ (hold other exogenous variables fixed). (c) In the early 1960s, the inflation rate in Japan was ___________ the inflation rate in the U.S. The last time that Canada had a fixed exchange rate was between the years 1962 and ________. (d) In the intertemporal model with money under a flexible exchange rate, the exact equation for interest rate parity is ________________________. The approximate version of the Fisher equation is written as _____________________. (e) In the intertemporal model with money under a flexible exchange rate, a temporary increase in the money supply results in ________ in the nominal interest rate and _________ in net exports. 

4. (a) Draw the diagram for the intertemporal model with money under a flexible exchange rate (label the axes). Show the initial equilibrium as point A. Suppose there is a future increase in the money supply (the current-period money supply is unchanged). Show the shifts in the curves (or lines), if any, and denote the new equilibrium as point C. Just draw the diagram; do not explain. (b) Consider the three-sector model with a fixed exchange rate. Using equations, explain what determines the ‘terms of trade’ in the domestic eco
nomy (suppose the domestic economy exports the resource good and imports the manufactured good).