1. Assume a small economy is open. According to classical economic theory, expla

Question

1. Assume a small economy is open. According to classical economic theory, explain what will be the long run effects of a decrease in government purchases. You need to present and discuss a formal model in detail for this question and then explain the implications of the model in the context of the question, i.e., explain the effects of expansionary fiscal policy in the model. You may want to organize your answer around three parts: a. Aggregate Supply/Output (includes a discussion of the determinant of the level of output and the effect of fiscal policy on output in the long run) b. Aggregate Demand/Real Expenditures (includes a discussion of components of expenditures, their determinants, and the effect of fiscal policy on expenditures and the composition of expenditures). c. Market for Foreign-Currency Exchange (includes a discussion of the determinant of the ex-change rate and the effect of fiscal policy on the real exchange rate in the long run).

Explanation / Answer

For the given part, assume there is a small open economy with perfect capital mobility and zero transaction cost. According to classical economic theory, a decrease in government purchases will leave the output and employment unchanged and there will only be a fall in the price level.

This final result can be interpreted in the following three steps:

Aggregate Demand - The Keynesian cross is a fundamental model of determination of income. The planned expenditure has three components: government spending, consumption spending and investment spending. Any change in these constituents alters the level of planned expenditure and thus liberates multiplied impact on income.

Since wages are prices are flexible, fall in output reduces wage and prices so that they fall in tandem. As soon as the price level falls real GDP returns to its potential level and the same level of output but with deflationary pressures is restored.

Demand for money falls as income. Interest rate falls and there is net capital outflow. This leads to depreciation of domestic currency and exports rise. Soon the terms of trade and current account is in surplus so that imports rise and exports fall. Income rises till it reaches its old potential level.

At the new equilibrium, only prices have fallen.

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