1. 3. East Bubble’s main trading partner is West Bubble. To fight inflation, West Bubble undertakes a contractionary monetary policy.

a. What is the effect of West Bubble’s contractionary monetary policy on East Bubble’s real exchange rate in the short run, assuming no change in East Bubble’s policies? In the long run? Use the Keynesian model with flexible exchange rates.

b. What is the effect of West Bubble’s monetary contraction on East Bubble’s nominal exchange rate in the short run and in the long run?

c. Suppose now that East Bubble has fixed its exchange rate with West Bubble. If East Bubble wants to keep the exchange rate equal to its fundamental value, how will East Bubble have to respond to West Bubble’s monetary tightening? What will happen to East Bubble’s output, real exchange rate, and net exports in the short run if it maintains the fixed exchange rate at its fundamental value? Compare your answer to that for part ( ).

a

d. Suppose that, after West Bubble’s monetary tightening, East Bubble decides not to change any of its own macroeconomic policies (the exchange rate is still fixed).

What will happen? Describe some alternative scenarios.