Question

Assume that the economy faces two shocks: a decrease in the world real interest and a decrease in government spending, both lasting for one period. Analyse the effects of these shocks on domestic short-run output, inflation and the real interest rate in the first two periods and in the long-run using the open economy AS/AD model of the textbook. Assume initially that domestic real output is on trend and the real interest rate is equal to the world real interest rate and inflation is at its target rate. Use a graph in you answer and provide an explanation of the adjustment mechanisms.

Answer 1

When real interest rate and government spending falls together, in IS-LM model, IS would shift leftward while LM would remain same. The interest rate would decline to i1 from i and output would decline from Y to Y1.

AD = C + I + G + X - M

When government spending falls, AD would decline while AS would remain the same. When AD decline, prices would decline from P to P1 and output would decline to Q1 from Q.

These are the impacts in short run. As prices declined in short run, inflation falls. Output is also falling in short run. In long run, output would be the same as Y and quantity sold be Q. LM would shift rightward as Fed would introduce rise in money supply which would give extra money in the hands of people which would raise the aggregate demand again and output would come at the same level at it was before. Here only interest rate falls while output is same and price comes at the initial level in the long run.