6 Flashcards
illustrate the effects of a temporary increase in the money supply on the DD and AA curves
explain the effects of a temporary increase in the money supply
↑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)
illustrate the effects of a temporary fiscal expansion on the AA and DD curves
explain the effects of a temporary fiscal expansion
↑G or ↓T = ↑ AD = ↑Y = ↑ real Md = ↑R = ↓E
illustrate how using a monetary policy helps maintain full employment after a temporary fall in demand for domestic products (recession)
explain how using a monetary (or fiscal) policy helps maintain full employment after a temporary fall in demand for domestic products (recession)
- ↓ demand for domestic products = ↓D = ↓DD = ↑E = ↓Y
- a temporary fiscal policy will shift back DD to initial position = restores currency to previous value
- a temporary monetary policy restores full employment by shifting AA = causes currency to further depreciate
illustrate how using a fiscal policy helps maintain full employment after a money demand increase (recession)
explain how using a fiscal (or monerary) policy helps maintain full employment after an increase in money demand (recession)
- ↑ Md = ↑R = ↓AA = ↓E = ↓Y
- temporary MS increase would shift back AA and E to initial level
- temporary fiscal policy shifts DD to the right: restores full employment, but involves greater currency appreciation
illustrate the short-run effect of a permanent increase in money supply
explain the short-run effects of a permanent increase in money supply
- 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
illustrate the long-run adjustment following a permanent increase in monetary supply
explain the long-run adjustment following a permanent increase in monetary supply?
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)
illustrate the effects of a permanent change in fiscal policy
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 ….
what does the domestic output depend on in the long-run?
In the long run, domestic output depends only on the available domestic supplies of factors of production
Y = A f(K,L,H,N)
in the short-run, what are the effects of a temporary increase in the money supply
shifts the AA curve to the right, increases output and depreciates the currency
what is the condition required for equilibrium output?
Y = C(Y-T) + G + I + CA(EP*/P, Y-T)
or
Y = D(EP*/P, Yd, I, G)
explain how the AA schedule is derived
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.
what are the main factors affecting the position of the AA schedule
- 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))
for asset markets to remain in equilibrium, a ride in domestic output must be accompanied by a …. of domestic currency, all else equal
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
Assume the asset market is always in equilibrium. Therefore a fall in Y would result in a … of the home currency
a depreciation of the home currency (mvmt along the AA curve to the left = E increases)
Assume the asset market is always in equilibrium. Therefore a fall in Y would result in a … of the home currency
a depreciation of the home currency (mvmt along the AA curve to the left = E increases)
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.
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.
in the short run, with price fixed, how would a temporary increase in gvt spending affect the DD-AA equilibrium?
DD shifts to the right : increase of output and currency appreciation
in the short-run, a temporary increase in gvt purchases will cause
a shift of the DD curve to the right and an increase in output
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.
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.
in the short-run, what are the effects of a temporary increase in money supply on the DD-AA equilibrium?
AA shifts to the right = Y increases = E depreciates
in the short-run, what are the effects of a tax increase on the DD-AA equilibrium?
tax increase = DD curve shifts to the left = Y decreases = E depreciates
what is inflation bias? what measures have gvnts taken to avoid it
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.
if the economy starts in the long-run equilibrium, a permanent fiscal expansion will cause
a decrease in exchange rate, E appreciates
in long-run equilibrium after a permanent money supply increase there follows …
an increase in exchange rate, E depreciates
what can offset a permanent increase in money demand
A permanent increase in money demand can be offset with a permanent increase in the money supply of equal magnitude.
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.
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.
in the short run, a permanent increase in the domestic money supply causes what effect on the AA-DD equilibrium
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)
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
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
what is the effect on the DD-AA equilibrium of a permanent fiscal expansion
DD shifts to the right while AA shifts to the left, leaving output the same and E decreased
Using the DD-AA framework, show the phenomenon of overshooting. Use a figure to explain when it is taking place.
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.
T or F: monetary expansion has no effect on the current account balance
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)
in the short run, monetary expansion causes the CA to …. and fiscal expansion causes the CA to …
in the short run, monetary expansion causes the CA to increase and fiscal expansion causes the CA to decrease
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)?
At first, home currency will appreciate as CA balance falls, but over time, currency will begin to depreciate.
The J-curve illustrates …
the short-term effects of depreciation on the current account
The percent by which import prices rise when the home currency depreciates by 1% is the degree of …
pass-through from exchange rates to import prices.
If a country’s nominal interest rate is zero, then
the country’s economy is in a liquidity trap.
When an economy is in a liquidity trap
monetary policy cannot be used to influence the exchange rate.
