Question

Canada is a small open economy, and our (by far) largest trading partner is the United States. Imagine that the US economy enters a significant recession due to COVID-19, but the Canadians do not get sick at all and everything works as usual in the Canadian economy. How would the US recession show in the Canadian economy? Use the IS-LM-FE model to explain what would happen to the Canadian real GDP and real interest rate and why. Discuss the effects of the US recession on the Canadian economy in the short run and in the long run.

Answer 1

When the US economy goes into recession , the demand for Canadian exports fall as US is the major trading partner of Canada.The aggregate demand falls and the IS curve shifts to the left.Thus the Canadian economy moves to short run recession.

In the IS-LM-FE model,the economy is in the long run equilibrium at Eo at output Y and price level Po.When the US economy goes into recession , the demand for Canadian exports fall as US is the major trading partner of Canada.The aggregate demand of Canada decreases and the demand curve shifts to the left.The Canadian economy moves to short run recessionary equilibrium at E1 with income Y1 and price P1.Real GDP falls below potential. Unemployment rises as a result.Supply of labour becomes more and wages fall.The short run aggregate supply curve ie LM will shift downward because of reduction in unit cost due to lower wages and the economy will move to a long run equilibrium at E2, with falling prices and rising output.Thus real GDP will be restored to potential ,and price level will be P2.The ecomomy will move from E1 to E2 and recessionary gap will be eliminated.

If the US economy goes into recession ,in the short run , the price level and real GDP of Canadian economy will decrease and unemployment will increase but in the long run there will be no change in GDPand unemployment ,only price level will decrease.