Question

4- Classical Model: The Long Run 1.1 Open Economy Solve for the following

Y, W P , L, C, I, Nx, r, i, Md ,  

when 4- the real rate of interest increases

answer key

1. Y , ¯ ¯ (W/P), L¯

2. r ?? C, I ?

3. r ?? CF ?? e ?

4. r ?? i ?? Md ?? P ?

5. e, P ?? E ?? Nx ?

Explain in as much detail as possible.

Nx = net expoet

r= real interst

i= nominal interst

Answer 1

When the real interest rate increases then as borrowing becomes more expensive then the level of money demand and investment will fall as borrowing becomes tougher. This in turn will cause the level of output to fall and so Y falls. As Y falls the level of the price level will decline over time as the AD curve shifts leftwards and so the real wage will rise and so W/P rises as its denominator falls. Consumption C will decline in such a situation as people find it tougher to borrow. This in turn will cause L to fall. As the real interest rate rises the currency appreciates and so net exports will worsen as imports rise and exports fall and so NX will decline. Given the Fishers equation as the real interest rate rises, the nominal interest interest rate will rise given the expected inflation rate and so we will have i that will rise. The demand for money Md will decline as the interest rates rise and people find it more expensive to borrow,