Suppose the government want to reduce budget deficit by decreasing spending.

a. Draw the IS-LM model, together with interest parity relation to show the effects on output, interest rate, and exchange rate. (7 points)

b. Why does output change? Why does interest rate change? Why does domestic currency appreciate or depreciate? Explain clearly. (7 points)

c. What happens to the components of demand? C, I, G, NX? Explain the reason for each. (9 points)

d. (Exchange rate and fiscal policy combination) Suppose that the economy is initially at its trade balance position (NX = 0). Draw the ZZ curve and NX curve to illustrate the effects of this contractionary fiscal policy on output and net export. Suppose the government want to maintain the trade balance. What exchange rate policy should be used and why? Illustrate the effects of this on your diagram. (7 points)