Answer to Question 1
The national defense argument is legitimate in those cases where domestic production is required. Problems include use in inappropriate situations as well as deadweight costs. A better policy would be to subsidize domestic production or subsidize imports during peace time.
Answer to Question 2
An increase in government spending will increase aggregate demand, which will shift the DD to the right. If AA remains unchanged, the new equilibrium will be at a higher Y and lower E. Since E is the nominal exchange rate, a lower E is an appreciation of the currency.
