Question

Real Shocks and the ‘Keynesian Cross’

Suppose the economy of Canada has reached the long-run equilibrium (i.e. full employment) and assume that the function of exports and imports are as follows:

(1) EX =α0 +α1q+α2(Y∗ −T∗)

(2) IMP =β0 −β1q+β2(Y −T)

where q is the real exchange rate between Canadian and US goods, Y − T is the Canadian disposable income, Y ∗ − T ∗ is the US disposable income, and the α’s and the β’s are positive parameters.

Assume that Prime Minister Trudeau decides to implements a temporary policy that convinces Canadians to buy less imported goods at any given real exchange rate and any given level of disposable income. In particular, assume that this policy lowers β0 in the import function shown above.

Explain how this temporary shock affects the level of output, consumption, investment, government expenditure, the nominal interest rate, the nominal and real exchange rates, and the level of prices in the short run. Use the AA-DD model to answer this question and do not forget to use a diagram to support your answer.

Answer 1

Shocks can be positive and negative. Positive demand shock occurs during an increase in AD facilitated from an increase in consumption or investment or government spending or export. It can also happen with a decrease in imports. We can show the effect of it in the short-run our AD-AS graph.

In our case, Prime Minister Trudeau has convinced citizens to buy less imported goods at a given exchange rate and a given level of disposable income. (Hence the question itself says that rearrangement will occur at the fixed exchange rate and disposable income) Further. it lowers the autonomous import function  β0.

Now as explained earlier that with the lowering of import, it would have a positive demand shock which causes an increase in aggregate demand. As given the market is Keynesian we have