1. Suppose that the Italian government budget deficit increases. What curves in the open-economy macroeconomic model...

1. Suppose that the Italian government budget deficit increases. What curves in the open-economy macroeconomic model shift? Explain why each curve shifts the direction it does.

Solutions

Expert Solution

1. Increase in GDP and price increase: Increased budget deficit will cause government expenditure to rise which has resulted in shift of AD to AD1. This will lead to increase nominla GDP and increase in inflation from P to P1.

2. Crowding out effect: Due to higher budget deficit government will crowd out savings in the country and borrow the same. This will result in shortage of savings for private sector which will then lead to interest rate increase.

3. Increase in interest rate: As government will borrow from public market it will increase the demand of funds in the market. If there will not be deficit monetization (increase in supply of money) this will lead to increased interest rate.

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