A country with C = 14 + .9YD, I = 15 − r, G = 5, T = 10 + .1y, AS = 5p, MD = .1y − r, MS = 5 and e

= 10 − r experiences a foreign AD shock when NX0 = 20 − .01Y − .5p + e decreases to NX1 = 5 − .01Y − .5p + e.

a. Provide diagrams for MS/MD and IRP, and supporting calculations, to illustrate the short-run

impact of this shock on interest rates and the exchange rate.

b. Explain what is meant by insulation in the context of this example.