Open Economy: Supply-Side and Demand-Side Shock, Insider-Outsider Model, Financial Crisis

Supply-side shock

Assume you are in a small open economy with flexible exchange rates.

The economy experiences a permanent positive demand shock.

• Draw the PC ?MR, the IS ?RX and the ERU ?AD graphs to help you explain the path back to medium run equilibrium.

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

• How does the medium run equilibrium vary from that in the closed economy?

Oil prices fell dramatically in 1986. Use the WS?PS and ERU diagrams to explain the effect of this supply-side shock on a small open economy. At the initial real exchange rate, what has happened to real wages and the level of employment?

Consult Chapter 11 and use the mathematics from Section 11.4.1 of the Appendix to derive the RX curve after a negative demand shock in bloc B.

Central bank has the following loss function:

Consult Chapter 13 to answer the following questions:

• What can we interpret about the central bank’s preferences from this loss function (Equation 13.1)?

• Briefly explain how this loss function compares to the standard loss function and a loss function with y^T> ye.
  
  
• Find the inflation bias for a central bank with this loss function (Equation 13.1).

Consult Chapter 15 to answer the following questions.

• How can the insider-outsider model explain persistently high levels of unemployment?

• Can this form of hysteresis be mitigated by increasing aggregate demand?

Assume an economy with lump-sum taxes is hit by a large negative demand shock (e.g. financial crisis). In response, the government introduces a large fiscal stimulus package to try and boost economic activity and help stabilize the economy. Assess whether the policy will be successful in each of the following cases:

• In the 3-equation model, when stimulus is financed through borrowing

• In the 3-equation model, when the stimulus is financed by raising taxes (i.e. a balanced budget expansion)

• In the RE ? PIH model, when the stimulus is financed through borrowing.

In which case will output expand the most? Justify your answer.