Question

B. Part 1: Think about the short-run effects of a temporary decrease in the U.S. real income. Illustrate your answer graphically.

Part 2: How will the below variables change in the short run compared to the initial equilibrium? Pick one option for each variable. (H stands for Home Country, aka the U.S.)

MH	Increase	Decrease	No change	Cannot tell
iH	Increase	Decrease	No change	Cannot tell
PH	Increase	Decrease	No change	Cannot tell

Answer 1

(Part 1)

A decrease in income will decrease aggregate demand. The AD curve will shift to left, decreasing both price level and real GDP, giving rise to a recessionary gap in short run (assuming initially the economy was at long run equilibrium). Unemployment rate will decrease.

In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect one another at long-run equilibrium price level P0 and real output (potential output) Y0. When aggregate demand decreases, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real output Y1, with short run recessionary gap (Y0 - Y1).

(Part 2)

When aggregate demand decreases, MH (money demand in US) will decrease.

When aggregate demand decreases, investment falls, so iH (interest in US) will decrease.

When aggregate demand decreases, PH (price level in US) will decrease.