Country A and B are small open economies. Their economies depend on each other heavily for trade, but their respective governments don't always work together when setting economic policy. Assume (for simplicity) that these countries only trade with each other. Country A decides to decrease domestic taxes to balance its budget.
1) How does country A's policy, assuming they have a floating exchange rate, immediately impact trade between the two countries? Explain answer with graph and two sentences.
2) Now assume Country B pegs their currency (fixed exchanged rate) to Country A's currency. How should Country B's central bank respond to Country A's policy to control short run output? How does Country B's new policy impact trade relative to BEFORE Country A changed their tax policy? Explain answer with graph and two sentences.
3) Suppose Country A's central bank contracted money supply to combat inflation simultaneously with their new tax policy (explained before part 1). With this new information, would your answer in part 2 change for Country B's optimal central bank policy to fix their exchange rate? Explain your logic.
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