Stabilization Policies in the AA-DD Model.
Suppose the economy of Zion has reached the long run equilibrium (i.e. full employment). Now assume that a best-seller, written by Neo and Trinity, entitled Buy Domestic Products convinces the public to consume less imported goods.
a Show how the fall in the demand for imports a ects the output of Zion in the short run.
Hint: use the Keynesian Cross model.
b Using the AA-DD model explain how the fall in the demand for imports a ects the AA and the DD schedules, the nominal exchange rate and output (recall that we are assuming that the economy was at its full employment level before this shock). Support your answer with a
graph.
c Describe how scal policy (taxes o government expenditure) can be used to restore full employment? What are the implications for the nominal exchange rate? (do not forget to include graphs to support your answer).