When solving the problems below, assume that prices are fixed and use ISLM model.

1. What are the effects of a decrease of foreign income under fixed and flexible exchange rate regime on domestic output, interest rate, exchange rate and net exports.

2. Analyze the effects of an:

• increase in taxation

• increase in government spending

• increase in money supply

on output, interest rate, exchange rate and net exports under fixed and flexible exchange rate?

3. In 1992 German mark was the “n-th currency” (what means that Germany could conduct an independent monetary policy, and all other EU countries had to adapt to it). Assume for simplicity, that the EU exchange rates were completely fixed. Show the effects of an increase in German interest rate on other EU economies. Why did some countries (like UK) decided to let their currency float?

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