1. both the LM and IS curves to move to the right.
2. the real exchange rate to fall permanently.
3. Π to fall permanently.
4. output to fall in the long run.
Choose the option above that is correct.
Option 3 is the correct one. Regardless of whether or not there is full employment, Π will fall. In the short run P will be fixed, but in the long run it must fall as wages and prices adjust to the decline in aggregate demand. In the short run LM will move to the left and drag IS with it as Π falls and Q rises, leading to a decline in Y . As prices fall in the long run, LM and IS shift back to the right to cross ZZ where output is at full employment. Ultimately, the real exchange rate cannot change so Π and P must fall in the same proportion.