Answer to Question #106755 in Macroeconomics for sara

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 .a)?

Answer 1

a) If the government increases temporarily its spending by ΔG, then the aggregate demand will increase, real output and price level will increase too.

b) If the government combines the temporary increase in government spending with a temporary increase in the money supply, then the increase in aggregate demand will be higher, and the interest rates will decrease additionally.