This question asks you to consider the effect of the COVID-19 crisis on US fiscal policy and global imbalances. Assume that the world has flexible exchange rates and is only made of two large economies: the USA (US) and EuroZone (EZ). US runs a current account (CA) deficit while EZ runs a CA surplus when the two countries are at their full employment equilibrium level, where the DD and AA curves intersect.

As the economy recovers, the Federal Reserve decides to increase its policy rate to stave off the risk of inflation. How does this affect the long run equilibrium in US and EZ in terms of output and the exchange rate? Explain.