Imagine that a single large country within the euro area, for example, Germany, carries out a fiscal expansion, in which its government purchases more of its own country’s output. What would be the effect on the other members of the euro area? 

a. Start by using the DD-AA model, considering the euro area to be a single economy with an exchange rate that floats against the rest of the world. Then consider the channels though which the German policy change could affect other currency union members if the change is permanent. What if it is temporary? 

b. Now imagine that the euro area is in a liquidity trap, with the ECB policy rate fixed at zero (recall Chapter 17). Referring to Figure 17-19, how do you think a temporary German fiscal expansion affects other currency union members? What about a permanent expansion?

Figure 17-19

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Exchange rate, E DD Ee 1- R* AA Output, Y yf