The economy of Oz has been in full equilibrium for long enough

The economy of Oz has been in full equilibrium for long enough that all economic agents have come to expect a particular price level. Government spending, tax rates and the money supply are all set exogenously.Use an IS-LM and an AD-AS diagram as aids to describing the effect of an unexpected shock to money demand that causes the LM curve to shift to the left. Consider each of three scenarios: Scenario A: The fiscal and the monetary authority have announced they will never respond to changes in the state of the economy. That is, policy-makers decide to do nothing in response to the LM shock.Scenario B: The monetary authority announces that it will never respond to shocks. The fiscal authority, however, announces that any shock that causes output to differ from the natural level will be met with a change in government spending designed to return output to full employment output.Scenario C: The fiscal authority announces that it will never respond to shocks. The monetary authority, however, announces that any shock that causes output to differ from the natural level will be met with a change in the money supply designed to return output to full employment output.For each of these scenarios, describe what happens to the price level, output, and the interest rate.Question Two: [10 marks]In order to reduce the size of its deficit, the government of Oz widely announces that it is considering introducing a large decrease in government expenditures next year. A substantial amount of opposition arises that claims such a move will cause a recession in Oz.You work for a corporation that is considering whether or not it should expand production. The economic viability of the plant expansion depends on there being no recession in the near future. Your boss asks you to comment on the validity of the claim made by those opposing the planned decrease in government expenditures. What do you tell her?Use appropriate well-labelled diagram(s) as an aid to presenting your report. Make clear any assumptions you make and discuss the implications of these assumptions.

 

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