Question

Consider a closed economy, make sure to include an explanation. Using an IS-LM-FE framework analyze the consequences of the following event according to a Real Business Cycle economist. Total factor productivity temporarily declines (adverse supply shock).

Answer 1

When an adverse shock supply occurs the demand for such products increase which causes aggregate demand to increase and hence prices increase.

As per IS LM FE graph, the supply shock causes the economy already at full employment to reduce to lower employment and shifts the LM Curve towards right untill interest rates fall which means no money supply increaseor decrease and as and when the interest rate decreases as shown in figure the LM curve shifts right which causes increase in prices. Since its closed economy interest rate changes. However its noted that when interest rates are raised again the LM curve shifts back.