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

Now assume that there is no law that requires the government to maintain a balanced budget at all times. Assume further that the government cuts taxes temporarily which leads to a budget deficit.

a) What is the overall effect on Y and E in the short-run if people expect that the government will finance its budget deficit by printing extra money in the future? Explain with the help of a figure.

b) Relative to part a), 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?