A financial crisis is a form of a large, negative, temporary but persistent demand shock in...

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Economics

A financial crisis is a form of a large, negative, temporary butpersistent demand shock in the money market such that costs ofborrowing unexpectedly increases for a given level of moneysupply.
1. Assume flexible exchange rate system. Use the IS-LM-FX modelto illustrate the short-run effects of a financial crisis onoutput, nominal interest rate, exchange rate and investment.
2. Suppose the goal of macro policy is to stabilize output inthe short run. What kind of fiscal policy would you recommend inresponse to the situation in Question 1?
3. Can we replace your fiscal policy in Question 2 with monetarypolicy? If you answer yes, explain what kind of monetary policy isdesirable. If you answer no, explain why.
4. Suppose that the central bank switches to a fixed exchangerate regime before the financial crisis. How will your answer inQuestion 3 change?
5. Is it possible that this economy remains stuck in loweroutput than before financial crisis despite efforts to stabilizeoutput? Explain your reasoning. Does your answer depends on theexchange rate policy?

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a If investment does not depend on the interest rate the IS curve is vertical The IS curve represents the relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services That is it describes the combinations of income and the interest rate that satisfy the equation Y CYT Ir G If investment does not depend on the interest rate then nothing in the IS equation depends on the interest rate income must adjust to ensure that the quantity of goods produced Y equals the quantity of goods demanded C I G Thus the IS curve is vertical at this level Monetary policy has no effect on output because the IS See Answer

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