Question
Consider an economy, which has a fixed exchange rate regime, is currently producing above its full-employment level of output. Believing the economy overheats, the central
Consider an economy, which has a fixed exchange rate regime, is currently producing above its full-employment level of output. Believing the economy overheats, the central bank decides to use contractionary monetary policy to cool down the economy.
a) Use the DD-AA model to demonstrate the effect of this change in policy on the country's level of output in the short run. Can the central bank achieve its goal by using contractionary monetary policy in the short run? (9 points)
b) What would happen to this economy in the long run? Explain in the context of the DD-AA model (Use the diagram you drew in part (a) to support your answer, no credit will be given if you draw a new one). (6 points)
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