Answer the following questions.
(a) 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.
(b) Using the relationships derived in problem (a), 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?
(c) What are the short run equilibrium effects of expansionary monetary policy in the DD-AA model? Make sure to analyze both temporary and permanent changes in monetary policy. What is the difference between these two scenarios with respect to equilibrium nominal exchange rate and output?
(d) How would your answer to question (a) change if all important contracts were sticky and could not change in the very short run?
(e) Discuss the following statement: Whenever the output is below potential and the government has a fixed exchange rate policy, it can use monetary policy to stimulate the economy and bring it back to full potential.
(f) Explain the concept of capital flight in the context of a fixed exchange rate regime. Make sure to include in the discussion what economic conditions would permit a country to establish such regime in the first place. Also, provide examples and reasons why such a regime might be sustainable.