1. the IS curve adjusts through changes in Π to bring about goods market equilibrium.
2. the LM curve and ZZ line alone determine the level of output at which the market for the domestic output flow will be in equilibrium.
3. the real exchange rate will increase in response to an increase in the demand for money when there is price rigidity and less-than-full employment.
4. all of the above will be true.
Choose the option above that is correct.
The right answer is option 4. Equilibrium is determined by the intersection of LM and ZZ. Under less-than-full-employment conditions these curves determine the equilibrium level of Y. The fixed level of the world real interest rate together with the given nominal money stock requires that Y adjust to maintain asset equilibrium. The nominal exchange rate must adjust to maintain equilibrium in the market for domestic output---that is, to ensure that IS crosses through the LM-ZZ intersection. When the demand for money increases, people try to sell assets abroad to acquire additional money holdings. This creates upward pressure on the external value of the currency with the result that Π falls and Q rises, reducing output and income and the current account balance.
Why is equilibrium determined by the intersection of LM and ZZ? Consider the LM equation.
r* = − (1/θ) M/P + γ/θ − τ + (ε/θ) Y
Given that r* is determined in the rest of the world, M is fixed by the government and τ depends on current information about the future, a given fixed level of P implies an equilibrium level of Y. The level of Y, however it is determined, must therefore be where LM crosses ZZ.