For this question, use the Keynesian IS—LM model with flexible exchange rates. Eastland's main trading partner is Westland. Suppose Westland undertakes an expansionary monetary policy
(a) What is the effect of Westland's expansionary monetary policy on Eastland's real exchange rate in the short run, assuming no change in Eastland's policies? (b) What is the effect of Westland's expansionary monetary policy on Eastland's real exchange rate in the long run, assuming no change in Eastland's policies? (c) What is the effect of Westland's expansionary monetary policy on Eastland's nominal exchange rate in the short run and in the long run?
(a) Since LM(West) shifts right, West's output rises, so East's net exports rise, so East's real exchange rate rises.
(b) In the long run, the real exchange rate will not change.
(c) In the long run, the West's price level rises, so East's nominal exchange rate must be higher to keep the real exchange rate unchanged.
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