(Short-Answer and Algebraic Questions): (The numbers in square brackets give the breakdown of the points for various parts of each question., please explain your answers.)

1. The COVID-19 pandemic in 2020 had devastating effects on Mexico's economy, as in many other countries. Mexican households' experienced significant restrictions in their access to many consumption goods and services. This meant that as a result of the pandemic, consumption expenditure had sharply declined for every given level of household real income and wealth. Furthermore, the prospects of reduced demand and production difficulties under pandemic conditions discouraged investment in the country. As a result, investment declined for every given rate of interest. These changes, however, did not change the price level, the net export function, or the propensity to hold money. Assume that the pandemic effects and any policy responses to them were all viewed as temporary by the households and firms. Also, assume that the interest parity condition held and money and product markets reached equilibrium in 2020. Finally, treat the conditions and policies in the rest of the world as given.

(a)If there had been no policy response to the pandemic, what would have happened to the aggregate preferred expenditure curve (D curve) of Mexico's economy in 2020? Why?

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(b)If there had been no policy response to the pandemic, what would have happened to the IS and LM curves of Mexico's economy in 2020? [Hint: Please keep in mind that we are assuming the propensity to hold money had not changed in 2020.]

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(c)If there had been no policy response to the pandemic, what would have happened to the equilibrium level of real income, nominal interest rate, exchange rate, and net exports of Mexico's economy in 2020?

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(d)In most countries shocked by the pandemic, central banks expanded money supply and governments increased their expenditures temporarily. In Mexico, the central bank adopted an expansionary monetary policy to substantially lower the interest rate so that it reached 4%, which was below the rate that would have prevailed in the absence of policy response as in part (c). But, unlike most other countries, the government of Mexico left its fiscal expenditure unchanged. How did these policies affect the equilibrium level of real income, exchange rate, and net exports, based on your analysis how these policy changes impacted IS and LM? [Treat the situation in part (c) with no policy change as the base case and compare the outcomes of intervention to that.]

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2. This question is based on the article, "Fiscal Multiplier at the Zero Bound: Evidence from Japan," by Ethan Goode, Zheng Liu, and Thuy Lan Nguyen, published on May 24, 2021, by the Federal Reserve Bank of San Francisco as part of its Economic Letters series. The article tries to assess the potential economic impact of the fiscal response to the COVID-19 pandemic in a situation when the interest rate has reached the zero lower bound (ZLB). For this purpose, it examines the size of fiscal multiplier (increase in GDP as a result of $1 increase is fiscal expenditure) under different circumstances based on the experience of Japan since 1980.

(a)As the article points out, economic theory predicts that compared with normal situations where the interest rate is above zero, the fiscal multiplier is larger when monetary policy is constrained by the ZLB. According to the article, what factors may explain this phenomenon? What role does the crowding-out effect play in lowering the fiscal multiplier in normal situations?

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(b)What is the range of multipliers that the article finds for normal vs. ZLB situations? How and in what ranges does the multiplier vary during recessions vs. expansions when the ZLB binds? Does the evidence presented in the article corroborate the claim that the multiplier is higher under ZLB conditions if there is a recession?

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