Two countries called East and West agree to unify. The real value of full-employment output in East is 1 trillion widgets, and in West it is 2 trillion widgets. The combined full-employment output of the unified country is expected to be the sum of the two full-employment outputs, or 3 trillion widgets.
Real money demand in the West is 10% of West's real output and will remain so after unification. In the East, people do not have access to financial instruments, such as stocks and bonds, and so are forced to save in the form of money. As a result, real money demand in the East is 40% of East's real output. However, after unification, Easterners will have access to a full range of financial assets, and thus, their real money demand will drop to 10% of output.
The unified country will use only the West's currency. As part of the unification plan, the West central bank has agreed to print new Western currency and trade it for Eastern currency, which will be destroyed. At the initial price levels, the total real value of the Western currency received by Easterners equals the total real value of the Eastern currency they give up.
Use the classical IS-LM model to find the effects on post-unification output and prices of the currency swap. Give a quantitative estimate of the effect on the price level (measured in the Western currency). Qualitatively, does your answer change if you use the AD-AS model based on the misperceptions theory? What can West's central bank do to offset the effects of the currency swap on the price level?