3. Investment, Keynesian Cross and the AA-DD model under a Flexible Exchange Rate. [53 points]

The Keynesian Cross we reviewed in class is given by the equality of actual output (Y) and Aggregate demand (AD)

=

=()

=+++(/,,)

Y=ADC=c(YT)AD=C+I+G+CA(eP

wheredenotes the marginal propensity to consume,, and the exogenously given Investment,taxes and government expenditures,

the nominal exchange rate,andthe domestic and foreign price levels, andand

Suppose that due to sudden news about widespread corruption in Country X,investment in that country declines temporarily from1 to2 with1>2. For simplicity assume that output was at its full employment level in Country X before the shock.

a)(7 points)Describe and show graphicallyhow this shock --the decline of Investment--affects theKeynesian Crossand the equilibrium income (Y). Label your Keynesian cross diagram properly and explain why the curves shift.

b)(7 points) Explain how does the change in the level of output (Y) in the previous part (parta) affect the real demand for money and the domestic interest rate in the short run?Use a diagram of the money marketof country X to support your answer. Explain why the curves shifts and why the variables change.

c)(9 points) Explain how does the change in the domestic interest rate inpart b(the previous part) affect the nominal exchange rate?Use a diagram of the foreign exchange marketto support your answer. Explain why the curves shifts and why the variables change.

d)(20 points)Use the AA-DD model to describe and to show graphicallyhow this temporary shock --the decline of Investment-- affects the nominal interest rate, the nominal and real exchange rates, consumption, exports, imports, the trade balance, andequilibrium income in the short run. Use an AA-DD diagram to support your answer.Explain why the curves shifts and why the variables change.

e)(10 points) Explain what type ofFISCALpolicy country X can implement to restore full employment after the decline in investment(contractionary or expansionary fiscal policy?).Support your answer with a graph of the AA-DD model. Explain why this policy is effective to offset the shock.