Answer to Question #152129 in Economics of Enterprise for Elsa

Question

We assumed that the country risk premium is exogenous in our analysis for simplicity. In reality, risk premium can fluctuate depending on the perceived economic outlook of a country. Let’s assume that a change in output affects the risk premium in the opposite way: an increase in output decreases the risk premium and a decrease in output increases the risk premium. Under this assumption, what happens to IS and LM curves, LRAS curve, real rental rate, investment, real exchange rate, real wage rate, and price level in short run and from short run to new long run if an economy is hit by an earthquake that lowers the existing capital stock without any change in the labor supply? Assume that the domestic country is small and it is operating under fixed exchange rate system.

Answer 1

The model is represented as a graph consisting of two intersecting lines. On the X-axis we have the real gross domestic product (Y), which is simply the output that the economy produces. On the Y-axis, we have nominal interest rates (i).

The intersection of the IS and LM curves shows the equilibrium point of interest rates and output when money markets and the real economy are in balance. If we move one of the two curves to the right or to the left, the model gives us a new set of economic output and interest rates.

IS Curve

Here, the interest rate is the independent variable while the level of income is the dependent variable. Notably, the curve is downward sloping. The IS also shows the locus point where total income equals total spending:

Y=C(Y-T(Y))+I(r)+G+NX(Y)

Where:

(Y) = income

(C(Y-T(Y))= consumer spending as an increasing function of disposable income

(l(r))= investment. A decreasing function of interest rates

(G)= government expenditure

(NX(Y)) = net exports