Question 1

1.1. Suppose a supply shock in the form of an earthquake causing big damage in most of the sectors of the economy.

Use the AD'-AS' model to illustrate and explain the impact of this supply shock on inflation and output in the short- and long term. (5)

1.2 Suppose policymakers come under political pressure to counter the supply shock by means of expansionary fiscal policy. Use the AD'-AS' model to illustrate and explain whether they will be successful. (4)

1.2. Briefly discuss the three arguments that explain the positive relationship between the average price level and aggregate production (positive slope of the AS curve). (3)

1.3. Use AD-AS analysis to show how each of the following events will affect the equilibrium price level and real output in an economy in the short run when the aggregate supply (AS) curve is upward sloping. In each case, draw and appropriate diagram.

1.3.1. Labour unions successfully negotiate an increase in nominal wages for their members. (4)

1.3.2. Consumer expects the economy to go into recession. (4)

Question two (20 marks)

2.1 Assuming fixed exchange rates and no capital mobility, explain the impact of a devaluation of the domestic currency in the Mundell-Fleming model. In your answer, clearly indicate the effect on income, rate of interest, and current account. Illustrate your answer graphically and explain the economics. (8)

2.2. In the Mundell-Fleming model with a floating exchange rate, what happens to aggregate income, the exchange rate, and the trade balance when the world interest rate rises? (8)

2.3. "Under a fixed exchange rate system and perfect capital mobility an increase in foreign interest rates will cause the level of domestic output to rise." Comment on this statement. (4)