A financial crisis is a form of a large, negative, temporary butpersistent demand shock in the money market such that costs ofborrowing unexpectedly increases for a given level of moneysupply.
1. Assume flexible exchange rate system. Use the IS-LM-FX modelto illustrate the short-run effects of a financial crisis onoutput, nominal interest rate, exchange rate and investment.
2. Suppose the goal of macro policy is to stabilize output inthe short run. What kind of fiscal policy would you recommend inresponse to the situation in Question 1?
3. Can we replace your fiscal policy in Question 2 with monetarypolicy? If you answer yes, explain what kind of monetary policy isdesirable. If you answer no, explain why.
4. Suppose that the central bank switches to a fixed exchangerate regime before the financial crisis. How will your answer inQuestion 3 change?
5. Is it possible that this economy remains stuck in loweroutput than before financial crisis despite efforts to stabilizeoutput? Explain your reasoning. Does your answer depends on theexchange rate policy?
