When there is a temporary shock to output (positive or negative), what happens to consumption in an open economy? A) It is unchanged. B) It changes by exactly the same amount as output. C) It changes by more than the temporary output gain or loss by a factor of (1 + r^*) / r^*. D) It changes by less than the temporary output gain or loss by a factor of r^* / (1 + r^*).

Question

Quizplus · Accepted Answer

In an open economy, when there is a temporary shock to output, consumption tends to be smoother than output due to the ability to borrow from or lend to the rest of the world. This means that consumption changes by less than the temporary output gain or loss, as individuals spread the impact of the shock over time. The specific factor provided in option D suggests a mathematical relationship that captures this smoothing effect, where r, S1, U1, P1, and P0 represent various economic parameters and variables.

When There Is a Temporary Shock to Output (Positive or Negative)