Question

Assumed that country Alpha is a small open economy in which has practiced a flexible exchange rate system. The economy has experienced a permanent positive aggregate demand shock due to an increase in consumer spending and private investment. Based on this situation:
a. Draw the PC-MR, the IS-RX, and the AD-ERU diagram to help you explain the path back to medium-run equilibrium (MRE).
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 which would occur in a closed economy subjected to the same shock.

Answer 1

a) The above diagram shows the IS-RX, PC-MR and the AD-ERU diagrams respectively. In the IS-RX diagram, a positive aggregate demand shock causes the IS curve to move towards right side. Hence output will increase to y0 in both IS-RX and PC-MR diagrams.With the increase in output above its equilibrium level, this will pushes inflation to π0 and the Philips curve shifts up to PC (π0) in the PC-MR diagram. In the last diagram, we can see the shift in the AD curve.In the open economy, the unique equilibrium unemployment rate has been denoted by the downward sloping ERU curve.

RX MR Yecio AD eRu BT AD

b)

In the above diagram, we can see the path of exchange rate after the positive aggregate demand shock.

c) The aggregate positive demand shock in a closed economy shows the new stabilizing real interest rates at medium - run equilibrium and the r0 affects the real economy that shifts the output to y1 and then the Central Bank adjusts r to move the economy along MR curve to equilibrium level.