Question

Consider the following short-run model of equilibrium in the foreign exchange market, money market, and goods market:

(1) R=R∗+Ee−EE,

(2) MsP=L(R,Y),

(3) Y=C(Y−T)+I+G+CA(q,Y−T).

All variables have the interpretation given in class (in particular, q=EP∗P is the country's real exchange rate).

Suppose that the government increases temporarily its spending by ΔG.

a) Explain how the endogenous variables of this model adjust to the new short-run equilibrium.

b) Suppose now that the government combines the temporary increase in government spending with a temporary increase in the money supply (both occurring at the same time). What can you say about the short-run response of output in this case compared to that in 3.a)?

c) Explain the intuition behind the difference in the response of output in questions 3.a) and 3.b).

d) Suppose now that the goods market equilibrium is given by

(3′) Y =C(Y −T)+I(R)+G+CA(q,Y −T),

instead of equation (3). Investment is now a decreasing function of the interest rate: when the interest rate increases (decreases), investment decreases (in- creases), all else equal. How does this change affect your answer to question 3.a)?

Answer 1

a) Suppose, if the government spending is increased by 1 Million USD then the impact on output will be determined by the money multiplier. The total increase in the output will be ΔG* Value of Multiplier = ΔY. Hence, output will increase by ΔG* Multiplier. When Government increases spending, it will give rise to higher employment which in turn will increase Consumption and Output. So, Agregate demand will also increase. This cycle will follow till the Output equals Aggregate Demand.. The end result would be higher output and higher prices.

b) If the money supply is also increased then both the IS and LM curves would shift to the right simultaneoulsy. When money supply is increased, the interest rates reduce which increases investment spending and consumption. The difference would be that the increase in output would be more than it was in a). The result would be a higher output and a higher increase in the overall price levels.

c) The main intuition is that there would be two stimulus increase output and employment. The use of fiscal policy and monetory policy simultaneously to increase output much more than either of the policies could have done alone, The government uses both policies for countries to come out of slowdowns and recessions.. Monetory policy is also used to stimulate the economy when in a recession by manipulating interest rates which can incfluence Private Investment Spending as well as domestic consumption levels.

d) It does not have any effect on a) as the interest rate was not affected and only the Government Spending was increased hence, there would be no impact or change