Consider a country operating under fixed exchange rates, with aggregate demand and aggregate supply given by equations (21.1) and (21.2):

Y= C (Y- T) + I (Y, i - ^e) + G + NX [Y, Y*, EP/p*]

Assume that the economy is initially in medium-run equilibrium, with a constant price level and output equal to the natural level of output. Foreign output, the foreign price level and the foreign interest rate are fixed throughout the problem. Assume that expected (domestic) inflation remains constant throughout the problem.

b. Now suppose that there is an increase in government spending. Show the effects on the AS-AD diagram in the short run and the medium run. How do output and the price level change in the medium run? (4 marks)