Use the IS-LM model to study the effects of fiscal policy in the form of a rise in government spending (such as that used in the fiscal stimulus policy pursued in the U.S. recently.) Make the usual IS-LM assumptions: consumption is a function of disposable income, investment is a function of the interest rate, and the trade balance is a function of the real exchange rate and income.

a) (10 pts) Use the ISLM and foreign exchange market graphs to show the short-run effects of a rise in government spending (temporary) if the country has a flexible exchange rate regime. Label the starting equilibrium point A, and the sort run equilibrium point B

State the direction of movement of the following variables (rise, fall, no change, not enough info): output ____________, interest rate ___________, investment _____________, exchange rate (domestic currency per foreign) ___________, trade balance ___________

b) (10 pts) Now suppose the country has a fixed exchange rate regime. Use the ISLM and foreign exchange market graphs to show how the shock would have affected the economy. Label the starting equilibrium point A, and the sort run equilibrium point B.

State the direction of movement of the following variables (rise, fall, no change, not enough info): output ____________, interest rate ___________, investment _____________, Central bank foreign reserves ________ trade balance ___________.

c)(5 points) Explain briefly whether countries with flexible exchange rate regimes should be more or less willing to use fiscal stimulus policy to fight a recession. Explain why.