Note: i) Y is real domestic output; ii) E is the exchange rate in domestic currency/foreign currency terms, iii) if a government maintains a balanced budget, this implies that total government expenditure is financed from government taxes . > implies there is a government budget deficit.

a) Assume that a country X has a law that requires its government to always maintain a balanced budget. Does this law imply that X can no longer use a temporary increase in government spending to increase aggregate output in the short-run?

b) What is the effect of a permanent increase in government spending on aggregate output in the short-run (for country X)? Explain with the help of a figure. For parts c and d, assume that there is no law that requires the government to always maintain a balanced budget. Assume further that the government cuts taxes temporarily which leads to a budget deficit.

c) What is the overall effect on Y and E in the short-run if people expect the government to finance its budget deficit by printing extra money in the future? Explain with the help of a figure. Note: printing extra money can be understood as a permanent monetary expansion.

d) Relative to part c), compare the effect on Y and E in the short-run if there is only a temporary decrease in taxes without the expectation that the government will monetize the debt in the future? Note: assume that the budget deficit is financed through some initial government wealth.