(c) Explain the differences between the uncompensated demand and the compensated demand. (6%)

Part II 1. Consider a Mundell-Fleming model (IS-LM-BP) for a small open economy with perfect capital mobility. The model is described by the following equations: Goods market: $$Y = C(Y) + I(r) + G + NX(e)$$ Money market: $$\frac{M}{P} = L(r, Y)$$ Foreign exchange market: $$r = r^*$$ where Y denotes output, C is consumption, I is investment, G is government spending, NX denotes net exports, r is the domestic interest rate, e is the exchange rate (defined as the amount of foreign currency per unit of domestic currency), and r* is the given world interest rate. Using this model, analyze the impact of an expansionary fiscal policy (an increase in government spending) on output and its effectiveness under (a) a floating exchange rate regime and (b) a fixed exchange rate regime. Illustrate your analysis using IS-LM-BP diagrams and provide a detailed explanation of how the economy adjusts to a new equilibrium. (10%)

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(c) Explain the differences between the uncompensated demand and the compensated demand. (6%)

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