1.2.2 Paranoia, the largest country in central Antarctica, receives word of an imminent penguin attack. The news causes expectations about the future to be shaken. As a consequence, there is a sharp decline in investment spending plans.

a. Explain in detail the effects of such an event on the economy of Paranoia, assuming no response on the part of the central bank or the Treasury (Ms, T, and G all remain constant.)

Make sure you discuss the adjustments in the goods market and the money market.

b. To counter the fall in investment, the King of Paranoia calls for a proposal to increase government spending. To finance the program, the Chancellor of the Exchequer has proposed three alternative options:

(1) Finance the expenditures with an equal increase in taxes

(2) Keep tax revenues constant and borrow the money from the public by issuing new government bonds

(3) Keep taxes constant and finance expenditures by printing new money Consider the three financing options and rank them from most expansionary to least expansionary. Explain your ranking.