Question

Suppose that large number number of refugees flee from a civil war and arrive in our country. Also suppose they are granted permanent resident status and are permitted to seek work.

Use ISLM + ASAD model to predict what will happen in the scenario above.

Indicate both the short run and long run. Label all clear starting and ending outcomes.

Answer 1

Let us assume that the economy is in long run equilibrium at full employment level as shown in the attached diagram.

If large number of refugees flee and are granted permanent residence in the domestic country, the short run effect of this change is that due to rise in the number of individuals in the economy, at every price level, the qauntity demanded will rise. This will shift the AD curve forward and will increase the income level in the economy and will lead to the rise in price level.

The rise in aggregate demand in the economy also implies that the IS curve will shift to the right. This is due to increased consumption in the economy. Thus, the new IS curve will intersect the LM curve at higher rate of interest and higher level of income.

Now, the rise in rate of interest will lead to crowding out effect in the economy. Also, when the output level increases beyond the potential level of income, it is the situation of more money chasing few goods which leads to inflation. This will movement on the aggregate demand curve in the backward direction. The supply curve will also shift backwards due tp inflation and decline in investment and eventually in the long run, the equilibrium is restored at the full employment level of output.

In the attached diagram, a= initial full employment equilibrium,

b= New short run equilibrium due to refugees.

c= New long run equilibrium.