To maintain the consistency, let us define nominal exchange rate as the amount of foreign currency required to buy one unit of domestic currency.

(a) You are the chief economic adviser in a small open economy with a floating-exchange-rate system. Your boss, the president of the country, wishes to increase the level of output in the short run in order to win reelection. Do you recommend using expansionary or contractionary monetary or fiscal policy? Why? Use the Mundell-Fleming model to illustrate graphically your proposed policy. Be sure to label: (i) the axes; (ii) the curves; (iii) the initial equilibrium levels; (iv) the direction the curves shift; and (v) the new short-run equilibrium.

(5 marks)

(b) The government of a small open economy with perfect capital mobility wants to establish a "stronger" currency by moving its exchange rate higher (i.e. requiring a higher amount of foreign currency in exchange for one unit of domestic currency). Suggest both an appropriate monetary policy adjustment and an appropriate fiscal policy adjustment that would allow the economy to move to a higher exchange rate. What are the consequences of these adjustments on domestic output and net exports?

(5 marks)