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Questions: Consider Earlgreyland together with a neighbouring country: Starbucksovia. These countries belong in a common currency union. Earlgreyland produces mostly black tea and Starbucksovia produces mostly coffee. Their common monetary policy is governed by the central bank of caffeine. Assume that both countries are initially producing at their natural rates of output.
i. Suppose that a news report comes out which states that caffeine is very harmful to your health. Use aggregate demand and aggregate supply to illustrate the effects of this report.
ii. As a result of the shock described in part a, do Earlgreyland and Starbucksovia regret that they formed a currency union? Could the central bank select a monetary policy which satisfies both countries?
iii. Suppose that instead, the news report states that only coffee is bad for you, but tea is actually very good for your health. Illustrate the effects using aggregate demand and aggregate supply. Do they regret the currency union now? Could the central bank select a monetary policy which satisfies both countries?
iv. From the situation described in part (b), what stabilisation policies are available to each country?
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