Macroeconomics

F I G U R E  

1 2 - 1 4

Real exchange  

rate, 

e 

Price level, P 

Income, output, Y 

Income, output, Y 

(a) The Mundell–Fleming Model 

(b) The Model of Aggregate Supply 

and Aggregate Demand 

Y 

e

1 

e

2 

IS* 

LM*(P

2

) 

LM*(P

1

) 

Y

1 

K 

C 

Y 

P

1 

P

2 

AD 

SRAS

1 

SRAS

2 

LRAS 

K 

C 

The Short-Run and Long-Run

Equilibria in a Small Open

Economy

Point K in both pan-

els shows the equilibrium under

the Keynesian assumption that

the price level is fixed at P

1

.

Point C in both panels shows

the equilibrium under the classi-

cal assumption that the price

level adjusts to maintain

income at its natural level Y−.

---

price level raises real money balances, shifting the LM* curve to the right. The

real exchange rate depreciates, so net exports rise. Eventually, the economy

reaches point C, the long-run equilibrium. The speed of transition between the

short-run and long-run equilibria depends on how quickly the price level adjusts

to restore the economy to the natural level of output.

The levels of income at point K and point C are both of interest. Our central

concern in this chapter has been how policy influences point K, the short-run

equilibrium. In Chapter 5 we examined the determinants of point C, the long-

run equilibrium. Whenever policymakers consider any change in policy, they

need to consider both the short-run and long-run effects of their decision.