Question:
In the model of exchange rate and output determination, explain how to derive the relationship between output and nominal exchange rates in both the output and the asset markets. Plot these relationships in one graph and explain the equilibrium condition.
(a) Using the relationships derived in problem 1, describe what happens to output and nominal exchange rates if the government decides to implement contractionary fiscal policy and people believe this policy is temporary. How would your answer differ if people believed this policy to be permanent?
(b) How would your answer to question (1) change if all important contracts were sticky and could not change in the very short run?