Economics 110B Spring 2012 Dr. Maria Cândido106.(12 points) Consider an open economy with fixed exchange rates and perfect capital mobility that is initially operating at the natural level of output. Throughout this problem, assume that foreign output, foreign interest rate and foreign price level are fixed. Also assume that the expected inflation remains constant. Now, suppose that the government reduces spending. a.Using the IS-LM framework, graphically illustrate and explain the short-run effects of this policy on the output, interest rate, exchange rate, and the components of demand (consumption, investment, exports, imports and net exports). b.To prevent any short-run change in the level of output when government spending is reduced, what kind of exchange rate policy should the government pursue? Explain. c.Suppose the government did not enact the exchange rate policy you suggested in part b. Using the AS-AD framework, graphically illustrate and explain the medium run effects of the reduction in government spending on output, domestic price level, real exchange rate, real interest rate, investment and net exports.