1. Consider a small open economy in which demand for real money is given by; Mt Pt = (1 + it+1)- Y where M is (exogenous) money supply, Pt is the price level, it+1 is the domestic interest rate and Y4 is (exogenous) real output. n and o are fixed parameters. (a) Write down an expression for the natural log of real money demand (using the result that, for small x, ln(1 + x) x and using lower case letters to denote the natural logs of levels variables. (d) Interpret the final form of the model. How do the exogenous right-hand side variables affect the exchange rate? (b) Also assume that PPP and UIP hold such that, in logs, we have; Pt = St + pH and it+1 = 2*+1 + Et(St+1) St = t where variables with a * superscript are those for the foreign country. Show that the nominal exchange rate can be written as; S+ = (mt byt + nit+1 P*) + n(Et(st+1) st) = Interpret this equation. (c) Solve forwards to show that the nominal exchange rate can be written as; S-t St = 1+02 (1+n). *E-(m. by+miot1 - P3) t Be explicit about any conditions that you have to impose in deriving this solution and interpret those conditions. 1. Consider a small open economy in which demand for real money is given by; Mt Pt = (1 + it+1)- Y where M is (exogenous) money supply, Pt is the price level, it+1 is the domestic interest rate and Y4 is (exogenous) real output. n and o are fixed parameters. (a) Write down an expression for the natural log of real money demand (using the result that, for small x, ln(1 + x) x and using lower case letters to denote the natural logs of levels variables. (d) Interpret the final form of the model. How do the exogenous right-hand side variables affect the exchange rate? (b) Also assume that PPP and UIP hold such that, in logs, we have; Pt = St + pH and it+1 = 2*+1 + Et(St+1) St = t where variables with a * superscript are those for the foreign country. Show that the nominal exchange rate can be written as; S+ = (mt byt + nit+1 P*) + n(Et(st+1) st) = Interpret this equation. (c) Solve forwards to show that the nominal exchange rate can be written as; S-t St = 1+02 (1+n). *E-(m. by+miot1 - P3) t Be explicit about any conditions that you have to impose in deriving this solution and interpret those conditions