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.

a. Draw an AS-AD diagram for this economy (3 marks).

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)

c. What happens to consumption in the medium run? (1 mark)

d. What happens to the real exchange rate in the medium run? (Hint: Consider the effect on the price level you identified in part [b].) What happens to net exports in the medium run? (2 marks)

e. Given that the exchange rate is fixed, what is the domestic nominal interest rate? Does the increase in government spending affect the domestic nominal interest rate? What happens to the real interest rate in the medium run? (Hint: Remember that expected inflation remains constant by assumption.) What happens to investment in the medium run? (4 marks)

f. In a closed economy, how does an increase in government spending affect investment in the medium run? (Refer to Chapter 7 if you need a refresher.) (2 marks)

g. Comment on the following statement. 'In a closed economy, government spending crowds out investment. In an open economy with fixed exchange rates, government spending crowds out net exports.' (2 marks)