Context: Y = 2500, Y-bar = 3000 :
If Y-bar = 3000, then (in the large open economy model) the economy would be in the expansion phase. Because the equilibrium output is less than the actual output. Equilibrium output shows the potential of the economy and if actual output is greater than the equilibrium output, then the economy would experience expansion.
Since there is a positive output gap in the economy i.e. actual output is greater than potential output. In this case, the economy is often described as "overheating," which generates upward pressure on inflation. And to offset the pressure on inflation, the federal bank would raise the interest rate as a monetary policy. Higher interest rates tend to moderate economic growth. Higher interest rates increase the cost of borrowing, reduce disposable income and therefore limit the growth in consumer spending. Higher interest rates tend to reduce inflationary pressures and cause an appreciation in the exchange rate...
Problem 1: Now suppose Y < Y bar and the economy is faced with a current account deficit. Using the large open economy model, analyze the impact of tax cuts on (i) GDP, (ii) r, (iii) C, (iv) I, (v) CF (vi) e, and (vii) NX in the short run.
Would there be crowding-out? Would it be complete or partial crowding-out?
If the Fed does not want a drop in I, what should it do?
Draw Graph if needed-
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