Suppose that the price level relevant for money demand includes the price of
imported goods and that the price of imported goods depends on the exchange rate.
That is, the money market is described by
M/P = L(r, Y ),

where

P = λP d + (1 – λ)P f /e.

The parameter λ is the share of domestic goods in the price index P. Assume that
the price of domestic goods P d and the price of foreign goods measured in foreign
currency P f are fixed.
a. Suppose that we graph the LM* curve for given values of P d and P f (instead of
the usual P). Is this LM* curve still vertical? Explain.
b. What is the effect of expansionary fiscal policy under floating exchange rates in
this model? Explain. Contrast with the standard Mundell–Fleming model.
c. Suppose that political instability increases the country risk premium and,
thereby, the interest rate. What is the effect on the exchange rate, the price level,
and aggregate income in this model? Contrast with the standard Mundell–Fleming
model.