Problem 3. Spillovers and International Transmission of Shocks Panama (Home) is a small open economy that pegs its exchange rate to the US (Foreign) dollar. Assume that shocks/policies of Panama have no impact on the US economy as it is a small country. We assume that investment in Panama only depends on the real interest rate so that when rates rise investment falls and vice versa. Formally, we can write I = I(R), I'(R) <0. We will say that a shock is transmitted positively from the US to Panama, whenever outputs of the US and Panama move in the same direction in response to that particular shock. A shock is transmitted negatively if the outputs of the US and Panama move in opposite direction. Furthermore, assume that all shocks analyzed below are temporary. (a) Using the AA-DD framework, show the effect a US monetary expansion (R* ↓) on output, inter- est rates, money supply, and the exchange rate in Panama. Do US monetary shocks transmit positively or negatively to Panama? (b) Do the same exercise but with shocks to US aggregate demand (Fiscal shocks, etc.). Do US ag- gregate demand shocks transmit positively or negatively to Panama? Now, suppose that Panama abandons its exchange rate peg to the US dollar. (c) Repeat part (a) under this scenario. (d) Repeat part (b) under this scenario. (e) Suppose that the goal of US monetary policy is to stabilize US output: when US aggregate demand increases (declines) beyond the natural level, US monetary authority contracts (expands) the money sup- ply. You also observe that aggregate demand shocks in the US and in Panama are correlated. In other words, when the US experiences an increase (decline) in its aggregate demand, Panama tends to experi- ence an increase (a decline) in its aggregate demand as well. Would a pegged exchange rate regime have a stabilizing effect on Panama's output? What if aggregate demand shocks in the US and Panama are uncorrelated (either move in opposite directions or do not occur at the same time)? (f) List the possible factors that might make the spillover effect stronger or weaker. (e.g. openness, degree of trade with the US, etc) Explain how those factors affects the above answers.