Fixed exchange rates and foreign macroeconomic policy Consider a fixed exchange rate system, in which a group of countries (called follower countries) peg their currencies to the currency of one country (called the leader country). Because the currency of the leader country is not fixed against the currencies of countries outside the fixed exchange rate system, the leader country can conduct monetary policy as it wishes. For this problem, consider the domestic country to be a follower country and the foreign country to be the leader country.

a. How does an increase in interest rates in the leader country affect the interest rate and output in the follower country?

b. How does the increase in leader country interest rates change the composition of output in the follower country? Assume the follower country does not change fiscal policy.

c. Can the follower country use fiscal policy to offset the effects of the leader country's reduction in interest rates and leave domestic output unchanged? When might such a fiscal policy be desirable?

d. Fiscal policy involves changing government spending or changing taxes. Design a fiscal policy mix that leaves consumption and domestic output unchanged when the leader country increases interest rates. What component of output is changed?