Question

Begin with 2 symmetric blocs. Now assume there is a permanent positive demand shock to bloc A and an equal and opposite permanent demand shock to bloc B. Describe the new medium-run equilibrim (MRE). [Hint: draw the AD-BT-ERU diagrams for the world, bloc A and bloc B before and after the shock]. Your answer should focus on the differences between the initial and new MRE. Don't discuss the adjustment path to the new MRE. How could you adjust the nature of the shocks so that there was a lower real interest rate in the new MRE?

Answer 1

Step 1. The graphs in the top line is showing the Symmetric Equilibrium and the Initial MRE.

Step 2. The graphs in the bottom line show the Asymmetric Equilibrium after the positive shock in block A and the negative demand shock in Block B.

Step 3.

• In Block A, appreciated real exchange rate and trade deficit is shown.
• In Block B, Depreciated real exchange rate and trade surplus is shown.
• The real interest rate and the level of out put remained unchanged in both the blocks.
• In the Global context the level of output and real interest rates remained unchanged.

Step 4. The diagram-