Question

Assume you are in a small open economy with flexible exchange rates. The economy experiences a permanent negative supply shock. (a) Draw the IS − RX, the PC − MR and the ERU− AD graphs to help you explain the path back to medium run equilibrium.

(b) Draw a graph of the real exchange rate over time and give a brief explanation of its path.

(c) How does the medium run equilibrium vary from that in the closed economy?

Answer 1

Anger The positive demound shock Shiffy the Is cuire. sight wally. This increase output to Yo which is above ig equilibrium lend and this Paphes up inflation to Tool in the next period, because of backward looking inflation expectations the Philips curre shifts upwardy to pc (To). The Central bank use the MR curve to find the outlet gol that will minimise their loss in depreciationt aq ni 화 ------- ----- ka tre time bank is To achieve needs to greater than this set the output gap the central the interest rate at so, which world interest rate 8* . The economy Then MR curve until brium any Inflation continue to oudgust down the output is back at excitin is bouck to og milial value

6) The foreign exchange Market is assumed to be aucting with rational expectation. They cause the read exchange rate to jump to an appreciates sate.... .. we can tell from the AO- ERU Diagroom that the exchange rate is appreciated by the new equil librium so that the real exchange sake can defeciate during the period where & excess of - This is necessary for the vil condition to hell. The interest sate gain from holding homes bondy need to be offset by the loss on holding homes currency. 1. Initial appreciation 2. Real exchange rate over Shoolis Equilibrium afprecation ISCA, 90) RX25(AG) . Yo Ye . Yey T I POTO) PC (Trx Depreciation ADO

e In the closed economy The Same Shosh. would -desult in a permanently higher stabilang rate of Interest. - Ол –та оfen econoy, m медият от equilibrium, & meyt equal g*. This means that the real exchange rate haft be more appreciated in the new equilibrium for output to be caud to equilibrium output and fch Inflatio to be constant .. in the closed economy, The demand stock is dealt with by a higher interest rate is suppressing interest rate sengative denard. In exchange rate an open economy ouppreciatas reducg net exporty output back which reduce to equilibrium