Question

Now, Assume that Peruvian government responds by using monetary policy to stabilize output after a shock. For each of the following situations, use the IS-LM-FX model to illustrate the effects of the shock and the policy response.For each case, state the effect of the shock on the following variables (increase, decrease, no change, or ambiguous): Y, i, E, C, I, TB.

a. Peru's main trading partner, China, enters into a recession. China's output decreases.

b. Investors expect a depreciation of the Sol, the Peruvian currency.

c. The money supply in Peru increases.

d. Peruvian government increases government spending.

Answer 1

Part A

When China’s output decreases, then IS shift to the left and DR shifts down. As a consequence, Y decreases, i decreases, E increases, C decreases, I increases, and TB increases. It is given in the following diagram,

FR LM1 A А i1 DR1 В i2 DR2 IS1 FR1 S2 E1 E2 Е Н/F Y2 Y1 Y

Part B

Suppose the Peruvian currency depreciates, then FR and IS shifts to the right and DR shifts up. As a consequence, Y increases, i increases, E increases, C increases, I decreases and TB increases.

ER LM1 B В DR2 A A i1 DR1 YS2 FR2 FR1 S1 Y Е Н/F E1 E2 Y1 Y2

Part C

The money supply in Peru increases, then LM shifts to the right. As a result, Y increases, i decreases, E increases, C increases and TB increases.

ER ŁM1 LM2 А i1 i1 DR1 В. В i2 DR2 2 IS1 FR1 Е Н/F E1 Е2 Y1 Y2 Y

Part D

The Peruvian government increases its spending then, IS shifts to the right and DR shifts up. As a result, Y increases, i increases, E decreases, C increases, I decreases, and TB decreases.

i ER LM1 В В i2 DR2 i2 A i1 A DR1 IS2 FR1 IS1 Е1 Y1 Y2 Е H/F Е2 Y