Liquidity traps and Zero Lower Bound (ZLB). This question studies the COVID-19 macroeconomic shock, where many central banks have his the ZLB on nominal interest rates. All the questions in Problem 3 are to solve for the short- run equilibrium.

Expansionary Fiscal Policy:

A) Plot an AA-DD diagram with the U.S. as home and the euro area as foreign. Suppose the Federal Reserve is initially at the ZLB and the U.S. economy is in a liquidity trap. Starting from the initial ZLB equilibrium, trace out the impact of a large temporary increase in government spending in the U.S. Assume that we are still at the ZLB after the fiscal expansion.

i. What happens to the U.S. AA curve? The U.S. DD curve?

ii. Does U.S. output rise, fall, or stay the same?

iii. Does the U.S. dollar appreciate or depreciate?

B) Now suppose the U.S. economy is not in a liquidity trap. Plot an AA-DD diagram which illustrates the effect of the same fiscal expansion policy discussed in part A) on output and the exchange rate.

i. Compare the effects of the fiscal expansion policy on U.S. output and the exchange rate when the U.S. economy is at the Zero Lower Bound in part A) and when the U.S. is not at the ZLB in part B).

ii. Explain why the fiscal expansion has a different effect on U.S. output and the exchange rate depending on whether the country is in a liquidity trap.