6

Question 1

illustrate the effects of a temporary increase in the money supply on the DD and AA curves

Answer 1

Question 2

explain the effects of a temporary increase in the money supply

Answer 2

↑MS = ↓R = ↑E = ↑AA = ↑Y (through the current account because domestic products become relatively cheaper than foreign products = exports, current account, aggregate demand and output increase)

Question 3

illustrate the effects of a temporary fiscal expansion on the AA and DD curves

Answer 3

Question 4

explain the effects of a temporary fiscal expansion

Answer 4

↑G or ↓T = ↑ AD = ↑Y = ↑ real Md = ↑R = ↓E

Question 5

illustrate how using a monetary policy helps maintain full employment after a temporary fall in demand for domestic products (recession)

Answer 5

Question 6

explain how using a monetary (or fiscal) policy helps maintain full employment after a temporary fall in demand for domestic products (recession)

Answer 6

1. ↓ demand for domestic products = ↓D = ↓DD = ↑E = ↓Y
2. a temporary fiscal policy will shift back DD to initial position = restores currency to previous value
3. a temporary monetary policy restores full employment by shifting AA = causes currency to further depreciate

Question 7

illustrate how using a fiscal policy helps maintain full employment after a money demand increase (recession)

Answer 7

Question 8

explain how using a fiscal (or monerary) policy helps maintain full employment after an increase in money demand (recession)

Answer 8

1. ↑ Md = ↑R = ↓AA = ↓E = ↓Y
2. temporary MS increase would shift back AA and E to initial level
3. temporary fiscal policy shifts DD to the right: restores full employment, but involves greater currency appreciation

Question 9

illustrate the short-run effect of a permanent increase in money supply

Answer 9

Question 10

explain the short-run effects of a permanent increase in money supply

Answer 10

• since P are fixed, ↑ Ms = ↓R = ↑E (to restore UIP)
• investors expect Ee to depreciate = further depreciation to restore UIP (E overshooting)
• this implies that AA curve shifts up more relative to a temporary increase is Ms = stronger effect on Y & E

Question 11

illustrate the long-run adjustment following a permanent increase in monetary supply

Answer 11

Question 12

explain the long-run adjustment following a permanent increase in monetary supply?

Answer 12

Pus increases and both AA and DD shift

• ↑P = ↓E = ↓EX & ↑IM = ↓CA = DD shifts left
• ↑P = ↓Ms/P = ↓AA (shifts left) = ↓E (permanently depreciated, but less relative to the short-run = overshooting)

Question 13

illustrate the effects of a permanent change in fiscal policy

Answer 13

Question 14

how is the AA schedule derived? The AA schedule has a … slope because a … in output leads to an … in the domestic interest rate and a domestic currency ….

Question 15

what does the domestic output depend on in the long-run?

Answer 15

In the long run, domestic output depends only on the available domestic supplies of factors of production

Y = A f(K,L,H,N)

Question 16

in the short-run, what are the effects of a temporary increase in the money supply

Answer 16

shifts the AA curve to the right, increases output and depreciates the currency

Question 17

what is the condition required for equilibrium output?

Answer 17

Y = C(Y-T) + G + I + CA(EP*/P, Y-T)

or

Y = D(EP*/P, Yd, I, G)

Question 18

explain how the AA schedule is derived

Answer 18

For a fixed real money supply, an increase in output leads to an increase in the domestic interest rate. In the foreign exchange market, an increase in the domestic interest rate leads to a lower nominal exchange rate, thus appreciating the currency. Therefore, the relationship between nominal exchange rate and output is negative; this leads to a negative slope of the AA schedule, which has the nominal exchange rate and output on its axes.

Question 19

what are the main factors affecting the position of the AA schedule

Answer 19

• changes in the domestic money supply (MS)
• changes in the domestic price level (P)
• changes in the expected future exchange rate (Ee)
• changes in the foreign interest rate (R*)
• shifts in the aggregate real money demand schedule (L(R,Y))

Question 20

for asset markets to remain in equilibrium, a ride in domestic output must be accompanied by a …. of domestic currency, all else equal

Answer 20

For asset markets to remain in equilibrium, a rise in domestic output must be accompanied by an appreciation of domestic currency, all else equal

mvmt along the AA curve towards the right = E decreases

Question 21

Assume the asset market is always in equilibrium. Therefore a fall in Y would result in a … of the home currency

Answer 21

a depreciation of the home currency (mvmt along the AA curve to the left = E increases)

Question 21

Assume the asset market is always in equilibrium. Therefore a fall in Y would result in a … of the home currency

Answer 21

a depreciation of the home currency (mvmt along the AA curve to the left = E increases)

Question 22

Use a figure to study the following question: Imagine that the economy is at a point on the DD-AA schedule that is above both AA and DD, where both the output and asset markets are out of equilibrium. Explain what will happen next.

Answer 22

Since the asset market adjusts very quickly, the exchange rate drops immediately to a point on the AA schedule. There will be excess demand for the domestic currency because the high expected future appreciation rate of the domestic currency implies that the expected domestic currency return on foreign deposits is below that on domestic deposits. This excess demand leads to an immediate fall in the exchange rate.

Question 23

in the short run, with price fixed, how would a temporary increase in gvt spending affect the DD-AA equilibrium?

Answer 23

DD shifts to the right : increase of output and currency appreciation

Question 24

in the short-run, a temporary increase in gvt purchases will cause

Answer 24

a shift of the DD curve to the right and an increase in output

Question 25

Using a figure show that under full employment, a temporary fiscal expansion would increase output (over-employment) but cannot increase output in the long run.

Answer 25

A temporarily fiscal expansion will move the economy from DD1 to DD2, and output increases. A permanent fiscal expansion will also shift the AA curve to the left and down. The nominal exchange rate appreciates, i.e. E decreases.

Question 26

in the short-run, what are the effects of a temporary increase in money supply on the DD-AA equilibrium?

Answer 26

AA shifts to the right = Y increases = E depreciates

Question 27

in the short-run, what are the effects of a tax increase on the DD-AA equilibrium?

Answer 27

tax increase = DD curve shifts to the left = Y decreases = E depreciates

Question 28

what is inflation bias? what measures have gvnts taken to avoid it

Answer 28

Inflation bias is caused when a government is expected to use policy tools to create an economic expansion (such as before an election). Because it is expected, wages and therefore prices are increased. If the government did not pursue the expansionary policy then, there would be a recession! Inflation is increased without the advantage of an increase in output.

Making the central bank independent of the political government is one answer to avoid inflation bias.

Question 29

if the economy starts in the long-run equilibrium, a permanent fiscal expansion will cause

Answer 29

a decrease in exchange rate, E appreciates

Question 30

in long-run equilibrium after a permanent money supply increase there follows …

Answer 30

an increase in exchange rate, E depreciates

Question 31

what can offset a permanent increase in money demand

Answer 31

A permanent increase in money demand can be offset with a permanent increase in the money supply of equal magnitude.

Question 32

A permanent increase in the domestic money supply must ultimately lead to a proportional …in E, and, therefore, the expected future exchange rate must … proportionally.

Answer 32

A permanent increase in the domestic money supply must ultimately lead to a proportional rise in E, and, therefore, the expected future exchange rate must rise proportionally.

Question 33

in the short run, a permanent increase in the domestic money supply causes what effect on the AA-DD equilibrium

Answer 33

a greater upward shift in the AA curve than that caused by an equal, but transitory, increase (AA shifts up more relative to temporary increase of MS = stronger increase effects on Y&E)

Question 34

in the short run, a permanent increase in the domestic money supply has … effects on the exchange rate and output than an equal temporary increase

Answer 34

in the short run, a permanent increase in the domestic money supply has stronger effects on the exchange rate and output than an equal temporary increase

Question 35

what is the effect on the DD-AA equilibrium of a permanent fiscal expansion

Answer 35

DD shifts to the right while AA shifts to the left, leaving output the same and E decreased

Question 36

Using the DD-AA framework, show the phenomenon of overshooting. Use a figure to explain when it is taking place.

Answer 36

The figure below shows the phenomenon of overshooting. A permanent increase in the money supply starting from full employment equilibrium will shift the AA curve to the right from AA1 to AA2. Now, a steadily increasing price level shifts the AA and the DD schedules to the left until a new long-run equilibrium is reached. Note that point 3 is above point 1, because Ee is permanently higher after a permanent increase in the money supply. The expected exchange rate, Ee, has risen by the same percentage as Ms. Notice that along the adjustment path between the initial short-run equilibrium (point 2) and the long-run equilibrium (point 3) the domestic currency actually appreciates (from E2 to E3) following its initial sharp depreciation (from E1 to E2). This exchange rate behavior is an example of overshooting, in which the exchange rate’s initial response to some change is greater than its long-run response.

Question 37

T or F: monetary expansion has no effect on the current account balance

Answer 37

F - monetary expansion increases the CA balance

Increase of MS = decrease of R = increase of E (depreciation) = AA shifts to the right = Y increases (through the CA as NX increase)

Question 38

in the short run, monetary expansion causes the CA to …. and fiscal expansion causes the CA to …

Answer 38

in the short run, monetary expansion causes the CA to increase and fiscal expansion causes the CA to decrease

Question 39

According to historical data, what is the effect of a sharp change in the current account on the exchange rate (both in the short and long run)?

Answer 39

At first, home currency will appreciate as CA balance falls, but over time, currency will begin to depreciate.

Question 40

The J-curve illustrates …

Answer 40

the short-term effects of depreciation on the current account

Question 41

The percent by which import prices rise when the home currency depreciates by 1% is the degree of …

Answer 41

pass-through from exchange rates to import prices.

Question 42

If a country’s nominal interest rate is zero, then

Answer 42

the country’s economy is in a liquidity trap.

Question 43

When an economy is in a liquidity trap

Answer 43

monetary policy cannot be used to influence the exchange rate.