International Economics 10th Edition by Paul Krugman,Maurice Obstfeld ,Marc Melitz

Exercise 12

Suppose interest parity does not hold exactly, but the true relationship is R = R * + ( E e ? E )/ E + ? , where ? is a term measuring the differential riskiness of domestic versus foreign deposits. Suppose a permanent rise in domestic government spending, by creating the prospect of future government deficits, also raises ? , that is, makes domestic currency deposits more risky. Evaluate the policy's output effects in this situation.