Question

Consider a world in which prices are sticky in the short-run and perfectly flexible in the long-run. APPP may not hold in the short run but does hold in the long-run. The world has two countries, the U.S. and Japan. Both countries are initially in a long-run equilibrium with fixed money supplies.

If real GDP in the United States were to fall temporarily, how would the real interest rate and the real exchange rate be effected? Give a detailed explanation.

Answer 1

If there is fall in the real GDP of the United States, there there will be slowdown in growth rate of the economy. This slow down might lead to foreign outflow of capital from the United States as investors fear of recession in the economy. Thus, foreign outflow will lead to fall in the level of real interest rate of the economy. Also real exchange rate of the economy will fall as there is fall in the demand of currency and this will lead to depreciation of economy's exchange rate. Thus, both real interest rate and real exchange rate of the economy will fall.