Suppose the country of Utopia is an open economy and its only trading partner is the United States. In addition, we assume that the uncovered interest parity (UIP) condition holds between both countries. The government of Utopia is currently running a budget deficit.
a) Assume the exchange rate between both countries is allowed to fluctuate freely. Suppose now that the government of Utopia intends to balance the budget. Use the IS-LM-UIP model to graphically illustrate and explain the effects of this policy change on the Utopian economy. In your graphs, clearly label all curves and equilibria.
b) Explain in words how would your answer in part a. change if Utopia would have pegged its currency to the US Dollar (i.e. Utopia operates under a fixed exchange rate regime)? Use a graph when answering this question. Explain your reasoning.
c) Does the above described policy change of the Utopian government affect Utopian investment and net exports the same under flexible and fixed exchange rates? Why or why not? Explain your reasoning.