In the New Keynesian open economy model with a fixed exchange rate, suppose that the output gap is initially zero and there is an increase in labour supply. What is the correct policy response
To keep the output gap at zero?

Question

Quizplus · Accepted Answer

An increase in labour supply will lead to a decrease in wages and therefore a decrease in prices, which leads to deflation. This will put downward pressure on the interest rate and cause demand for money to decrease. To keep the output gap at zero, expansionary monetary policy is needed to increase demand for money and offset the deflationary pressures. Increasing government spending will help to increase demand and keep the output gap at zero.

In the New Keynesian Open Economy Model with a Fixed