Question 3: IS-LM model in an open economy with fixed exchange rates (30 Marks) We will use the economy you examined in Question 2 (reproduced here for convenience) to study the case of fixed exchange rates. You are to assume that the government pegs the nominal exchange rate at the level you found in part c) of Question 2. Ma = 21+0.5Y -400r Money demand P C" =18+0.6(Y -T)-200r" Desired consumption * = 28-200r" Desired investment NX= 24-0.1Y -2e Desired net exports Y = C +/'+G+ NX* Goods market equilibrium The government is under protectionist pressures from its trading partners to lower net exports. As bright, young economists, you are called upon to evaluate the following three options: a) Raising the current value of the peg by 10%; b) Introducing structural reforms that would have the effect of raising potential output by 1% and eventually aggregate demand by the same amount; or c) Increasing government spending by 10% but no change in potential output. In each case, use the model to find both the short-run and the long-run effects of the policy options on the levels of Y, e, P and NX. 1. Explain briefly the effectiveness (or ineffectiveness as the case may be) of each option in both the short and long term. 2. Based on your analysis, which policy option would be the most effective in reducing the country's net exports (NX)? 3. Which policies are deflationary and which are inflationary? [Note: For part b) you can assume that the economy is in short-run equilibrium and that potential output has shifted by one percentage point.]