Answer to Question #106757 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) (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 .a)?

Answer 1

a) this will lead to an increase in aggregate output, which automatically increases the aggregate demand and parameters of the system of national accounts. In the end, this leads to an increase in output in most cases.

b) When the state increases its expenses, it needs money in the financial market. Thus, the demand for money is growing in the leverage market. This leads to the fact that banks raise prices for their loans, that is, increase their interest rates for reasons such as the motivation for maximizing profits or simply not enough money to issue loans. Increase in the interest rate is not liked by investors and entrepreneurs of firms, especially start-ups, when the company does not have its own "starting" money capital. As a result, due to the high interest rates of banks, investors have to take less loans, which leads to lower investment in the country's economy. Thus, a stimulating fiscal policy is not always effective, especially if a business of any kind does not develop properly in a country.