We assume that the r in our small open economy is

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Unformatted text preview: clearing level of labour employment is inserted Page 36 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 into the production function. The short run equilibrium of the economy is where the IS curves crosses the LM curve. If an economy is in equilibrium below the natural level of output, eventually the low demand for goods and services causes prices to fall, and the economy moves back to its natural rate. This long- run equilibrium is achieved in the IS- LM model by a shift in the LM curve: the fall in the price level raises real money balances and therefore shifts the LM curve to the right. We can now see the main difference between Keynesian and classical approaches to the determination of national income. The Keynesian assumption is that the price level is stuck. Depending on monetary policy, fiscal policy, and other determinants of aggregate demand, output may deviate from its natural level. The classical assumption is that the price level is fully flexible. The price level adjusts to ensure that national income is always at its natural level. The Great Depression In Canada, it was caused by the drop in exports to the United States since that is such a large fraction of Canadian GDP. But what caused the Great Depression in the United States? The spending hypothesis: shocks to the IS curve Falling interest rates in the early 1930s indicates that the decline was caused by a contractionary shift in the IS curve. It places the blame for the Depression on an exogenous fall in spending on goods and services. A downward shift in the consumption function may be the cause of this, as the stock market crash induced consumer to save more of their income. A drop in investment in housing is another option. Residential investment in the booming 1920s was excessive, so demand for residential investment may have declined dramatically. The drop in residential investment may also have been caused by a drop in immigration in the 1930s, decreasing demand for new housing. Widespread bank failures may have reduced investment since banks play a crucial role in getting funds to investors. Finally, U.S. fiscal policy caused a contractionary shift in the IS curve. They raised taxes and reduced government spending. The money hypothesis: a s...
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