Question

1. Canada is an open economy that is currently in a recessionary output gap (a) Draw a correctly labeled graph of the long-run aggregate supply, short-run aggregate supply, and aggregate demand curves, and show each of the following (i) The current equilibrium real output and price level, labeled as Y, and PL, respectively (ii) Full-employment output, labeled Y (b) The central bank and the government do not take any policy actions to close the output gap (i) Explain how the economy will adjust to full employment in the long run (ii) On your graph in part (a), show how the economy adjusts to full employment in the long run (c) Suppose the Canadian government is unwilling to wait for the long-run adjustment process. The marginal propensity to consume is 0.8. The equilibrium real output is $500 billion and the full-employment output is $540 billion (i) Calculate the minimum change and indicate the direction of change in government spending required to shift the aggregate demand curve by the amount of the output gap (ii) Calculate the minimum change and indicate the direction of change in taxes required to shift the aggregate demand curve by the amount of the output gap (d) Assume instead that the Canadian central bank takes actions to restore the economy to full-employment output by influencing investment spending. Draw a correctly labeled graph of the money market, and show the effect of the actions taken by the central bank on the equilibrium interest rate (e) Canada and Mexico are trading partners. Draw a correctly labeled graph of the foreign exchange market of the Canadian dollar, and show the effect of the change in the interest rate in part (d) on the value of the Canadian dollar with respect to the Mexican peso

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Answer 1

(a) The diagram depicts that initial equilibrium occurs at point E_1 where output is lower than the Natural level of output y_f and economy is in the recessionary gap (b). In the long run, real wages will decline and the S R A S curve will shift rightwards to S R A S^1 and new equilibrium will occur at point E_2 where economy has attained its new equilibrium It is shown in the diagram above (c) M P C = 0.8, delta y = $ 40 billion delta y = 1/1 - M P C times delta G: delta G = $ 40 billion times 0.2 = $ 8 billion delta y = M P C/1 - M P C times delta T: delta T = $ 40 billion times 0.2/0.8 = $ 10 billion (d). The central bank will increase the level of money supplied in money market to M^1 and this reduces rate interest increasing investment spending