Assume Smithland is in short-run equilibrium at a level of output that exceeds the full-employment level of output.

(a) Draw a correctly labeled graph of the aggregate demand, short-run aggregate supply, and long-run aggregate supply curves, and show each of the following.

(i) The current equilibrium real output and price level, labeled Y1 and PL1, respectively

(ii) The full-employment output, labeled YF

(b) Assume Smithland's government cuts individual income taxes. On your graph in part (a), show the short-run effect of the tax cut on equilibrium real output, labeling the new short-run equilibrium real output Y2.

(c) Based solely on the change in real output on your graph in part (b), what will happen to each of the following in the short run? (i) The natural rate of unemployment (ii) Nominal interest rates. Explain

(d) Assume instead the central bank intervenes to correct an inflationary output gap. What open-market operation should the central bank take?

(e) Draw a correctly labeled graph of the money market, and show the effect of the open-market operation identified in part (d) on the nominal interest rate.

(f) Based solely on the interest rate change identified in part (e), what will happen to the international value of Smithland's currency in the foreign exchange market? Explain.

(g) Based solely on the exchange rate change identified in part (f), will Smithland's imports increase, decrease, or remain the same? Explain.