Y is real domestic output; ii) E is the exchange rate in domestic currency/foreign currency terms, iii)

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Y is real domestic output; ii) E is the exchange rate in domestic currency/foreign currency terms, iii) if a government maintains a balanced budget, this implies that total government expenditure G is financed from government taxes T. G > T implies there is a government budget deficit.

For parts a) b) c) and d), assume

i) Investment I is fixed.

ii) The government only purchases domestic products.

iii) Aggregate consumption C is composed of domestic and foreign products.

iv) Households' marginal propensity to consume out of disposable income is less than one.

In addition, assume, for parts a) and b) that country X has a law that requires its government to maintain a balanced budget (G = T) at all times.

a) Does this law imply that X can no longer use a temporary increase in government spending to increase aggregate output in the short run?

b) What is the effect of a permanent increase in government spending on aggregate output in the short run (for country X)? Explain with the help of a figure.

For parts c) and d), assume that there is no law that requires the government to always maintain a balanced budget. Assume further that the government cuts taxes temporarily which leads to a budget deficit.

c) What is the overall effect on Y and E in the short-run if people expect the government to finance its budget deficit by printing extra money in the future? Explain with the help of a figure. Note: printing extra money can be understood as a permanent monetary expansion. (3 marks)

d) Relative to part c), compare the effect on Y and E in the short-run if there is only a temporary decrease in taxes without the expectation that the government will monetize the debt in the future. Note: assume that the budget deficit is financed through some initial government wealth.