Suppose that Korea’s economy is initially in a long-run equilibrium. Then the country’s Ministry of Strategy and Finance decides to increases the government purchases.

a. Using the Keynesian cross, demand-supply in the money market and the IS-LM model, explain the consequence of this fiscal expansion. What happens to consumption, investment and the real money demand? What happens to the equilibrium interest rate and RGDP (total expenditure)?

b. How does your result in part (a) affect the aggregate demand? Explain what happens to the price level and the equilibrium RGDP in the short run by using the AD-SRAS-LRAS model and the labor market. Assume that people (firms and workers) may have misperception about the price level so their expectations on the price level, Pe , may not be equal to the actual price level, P.

c. How does Korea’s economy adjust in the long run? Explain how the change in people’s expectations on the price level leads the economy to a new long-run equilibrium. You may add the long-run adjustment in your diagrams in part (b).