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Economics 3301.1
1. With the help of the IS-LM open economy model with perfect mobility, examine the short-run
impact of each of the following on equilibrium output, interest rates, and investment, and net
exports under flexible exchange rates. You must draw graphs to support your answers.
• A worsening of business expectations
In case of a foreseeable crisis in terms of business expectations, such as an economic
recession affects the IS curve and not the LM curve as it causes a change in the
aggregate demand. Worsening expectations causes the consumers and investors to
lose confidence in the economy and as a result, the IS curve shifts to the left reflecting
the decrease in aggregate demand for goods and services. The output level in the
economy decreases from Y0 to Y1. Besides, the level of investment decreases as
consumers decide to save more in preparedness for worse times ahead. The budget
deficit in the economy which may result from reduction in output and incomes causes
the local currency to appreciate and therefore the level of net exports decreases.
•
A monetary expansion accompanied by a fiscal expansion
An expansionary monetary policy will shift the LM curve to the r...