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3.Canada is a small open economy, and our (by far) largest trading partner is the United...

3.Canada is a small open economy, and our (by far) largest trading partner is the United States. Imagine that the US economy enters a significant recession due to COVID-19, but the Canadians do not get sick at all and everything works as usual in the Canadian economy. How would the US recession show in the Canadian economy? Use the IS-LM-FE model to explain what would happen to the Canadian real GDP and real interest rate and why. Discuss the effects of the US recession on the Canadian economy in the short run and in the long run.

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Answer #1

The recession in the economy of USA would reduce the aggregate demand . The fall in the aggregate demand would shift the demand for Canada export downward.

Thus it would affect the IS curve negatively. The IS curve shifts downwards.

Following is the diagram:

Here, the IS curve shifts down due fall in the net export , so here interest rate and output both decline.

The exchange rate also declines here.

Over the long run again the low exchange rate would incentivise export and again IS curve will shift to right thereby restoring equilibrium in the economy.

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