This question is about a small open economy that has a fixed exchange rate. Suppose a wave of pessimism sweeps the country such that both households and firms decide to spend less. To make things worse, the market believes this wave of pessimism has a permanent effect on the economy. a) What happens to output in the short run? Explain and support your answer by one DD-AA diagram (only the first diagram will be graded). (6 points) b) Instead of having fixed prices in the short run, prices are flexible in the short run. What happens to output in the short run? Explain and support your answer by the DD-AA diagram you drew in part (a). No credit will be given if you drew a new diagram. (8 points)

c) Based on your answers in previous parts, would the inability to use monetary policy to smooth out business cycles be a problem? Yes/No, explain. (6 points)