Analyze the effects of each of the shocks below using the three diagrams I have
ID: 1115288 • Letter: A
Question
Analyze the effects of each of the shocks below using the three diagrams I have been using in class: the IS-LM diagram, the money market diagram, and the FX market diagram. In each diagram, use point A to identify the initial, pre-shock macro equilibrium; use point B to identify the new equilibrium once the economy has adjusted to the shock, assuming no change in the money supply; use point C to identify the new equilibrium assuming that the home country adjusts its money supply to keep domestic output (Y) at its initial, pre-shock level; and use point D to identify the new equilibrium assuming instead that the central bank adjusts the money supply to keep the exchange rate at its initial, pre-shock level. So, for each shock, there will be three diagrams with each diagram containing the four points A-D. Be sure to label your diagrams fully and show all of the involved shifts of curves.
Do this for each of the following shocks:
1. a decrease in individual income taxes (T)
2. an increase in home country money demand (L)
3. a rise in the expected future value of the home country’s currency exchange rate
(be careful in interpreting E)
Explanation / Answer
Aggregate demand will decrease, IS curve will shift to the left. LM curve shifts to the right, thereby decreasing interest rate and increasing total output. As a result of decrease in interest rate, investment increases, thereby increasing the demand for domestic currency, shifting the demand for home currency curve to the right, eventually leading to an increa FX curve will shift to the left se in interest rates.