Suppose Italy's economy is in a recession, ie <. Suppose, further, that Italy's Prime Minister is tired of Brussels's budget discipline demands and exits EMU and then pursues such an expansionary fiscal policy that the economy immediately returns to a neutral state of the economy.

a) Analyze the short-term effects on GDP and price level using Blanchard's AS-AD model for an open economy.

b) How will the exchange rate of the Italian currency move according to the theory of purchasing power parity?

(Assume that Italy's real exchange rate was in medium-term equilibrium when it left the currency union and that the price level remains unchanged in the rest of EMU).