When East Germany and West Germany were reunited in 1990, the exchange rate between the two countries was irrevocably fixed. In a symbolic gesture of equality between the two countries, it was decreed that one East German mark would be worth the same as one West German mark, even though the currency of the East was in reality worth much less.

1. Think of East Germany as the domestic economy. Suppose East Germany is initially in medium-run equilibrium before reunification (obviously a counterfactual assumption here, but one has to start somewhere...) and suppose that the exchange rate (vis--vis West Germany) is set much too low. Discuss the impact of that decision on equilibrium output and unemployment using AS-AD analysis.
2. What happens over time?
3. Suppose that prices in Western Germany are constantthere is no inflation. What has to happen to prices and wages in Eastern Germany?