Question

1. A country with a floating exchange rate is at full employment (actual GDP = potential GDP) with stable prices.  A new president is elected and decides to increase government spending.  

1. What will happen to actual GDP if monetary policy doesn’t change?
2. How should monetary policy change to keep prices stable and prevent actual GDP being different from potential GDP?

What will happen to the interest rate, the exchange rate, investment, consumption, and net exports in the short run when prices are sticky?  Use diagrams for the goods market (Keynesian cross), money market, FX market, and IS-LM diagram to explain your answer

Answer 1

A) increase in government spending will increase aggregate expenditure and thus aggregate demand. So as a result of Increase in aggregate demand ,real gdp will increase .

So GDP will increase above full employment , shortage of workers will result in increase in wages and thus lead to increase in prices and inflation.

B) The central bank should use a contractionary monetary policy to counter the effect of increased government spending.

Fed Should Decrease money supply by selling Treasury bonds to public and banks through open market operations or increasing required reserve ratio.

Bu this, money supply will decrease.

Decrease in money supply will create a shortage of money at initial equilibrium interest rate. To eliminate shortage or decrease money demand, interest rate rises ,so that money market reaches equilibrium.

So interest rate rises.

Increase in interest rate will make domestic assest more profitable than foreign,so it will attract foreign investment,so it increase demand of domestic currency and thus increase exchange rate or value of domestic currency.

Because equilibrium income will remain same,so there will be no effect on consumption.( But in permanent income theory, consumption also depends on interest rate,so in that case consumption will decrease).

Increase in exchange rate, imports will become cheaper , so imports will increase . For foreigners, domestic good will become expensive,so export will decrease. As a result net exports will decrease.