Final answer:
An increase in foreign income, y★, leads to an increase in exports and higher aggregate demand, causing the IS curve to shift to the right, with the LM curve remaining unchanged. The Interest Parity curve is not directly affected in this simple analysis.
Step-by-step explanation:
When considering how an increase in foreign income, y★, affects an economy under a flexible exchange rate system, we can analyze its impact on the IS-LM-UPP model. An increase in foreign income can lead to an increase in an economy's exports, as foreign consumers now have more income to spend on goods and services, including those imported from the analyzed economy. This rise in exports boosts aggregate demand, causing the IS curve to shift to the right. This increase in aggregate demand leads to a higher real GDP and has the potential to apply upward pressure on the price level. However, it doesn't directly affect the money supply or the demand for money, leaving the LM curve unchanged.
Regarding the Interest Parity curve (UPP), an increase in foreign income can lead to changes in both domestic and foreign interest rates due to capital flows responding to changes in expected returns. Nonetheless, in the simple context of IS-LM-UPP analysis, we do not assume immediate changes to the UPP due to shifts in the IS curve.
The correct answer to this situation, as it lays out on the IS-LM-UPP diagram, would be option b: The IS curve shifts to the right; the LM curve does not shift; the Interest Parity curve does not shift.