Question

Consider the following situation. freedonia is a country open to international transactions that maintains good relations with all other countries. however, freedonia has observed that external conflicts involving those other countries have raised the price level abroad (its main trading partners are experiencing widespread price inflation). question! if freedonia's economy is currently operating close to full employment, how could the increase in the price level abroad initially affect freedonia's aggregate output (y), price level (p) and interest rate (i) in the short run?

Try to use the ad-as is-lm model assuming first that there is room for the product to grow (horizontal sras curve). this will tell you the direction of y and i. then imagine that there is not much room for the product to grow (upward sloping sras curve). this will tell you that the impact on y will be smaller because some of what would be an impact on y will actually become an impact on p. keep in mind that the exercise is only asking about the short run.
a. we can expect y to increase, p to increase, and i to increase.
b. we can expect y to increase, p to remain unchanged, and i to remain unchanged.
c. we can expect y to decrease, p to decrease, and i to remain unchanged.
d. we can expect y to decrease, p to decrease, and i to decrease.
e. none of the alternatives is correct.

Answer 1

In the short run, an increase in the price level abroad would initially affect Freedonia's aggregate output, price level, and interest rate in different ways depending on the slope of the SRAS curve.

Step-by-step explanation:

In the short run, an increase in the price level abroad would initially affect Freedonia's aggregate output (Y), price level (P), and interest rate (I) in the following way:

1. Assuming there is room for the product to grow (horizontal SRAS curve), the increase in the price level abroad would increase aggregate demand (AD), leading to an increase in aggregate output (Y), price level (P), and interest rate (I).
2. Assuming there is not much room for the product to grow (upward sloping SRAS curve), the impact on aggregate output (Y) would be smaller because some of the increase in price level (P) would be absorbed as an increase in price rather than output. Interest rate (I) would remain unchanged in this scenario.