6. Output and Exchange Rates in the Short-Run

Question 1

What two factors determine the current account balance

Answer 1

1. Domestic disposable income (Y-T)
2. Real Exchange Rate
   - Defined as the price of a foreign basket in terms of the domestic one
   - (q=EP/P) where E is in terms of domestic/foreign, P is the foreign price levels, and P is domestic price levels
   - When q increases, the CA improves because it implies that the price of foreign goods is relatively more expensive

Question 2

What does aggregate demand depend on?

Answer 2

1. Disposable income (directly proportional)
2. Real Exchange rates (directly proportional)
   - A depreciation of domestic currency increases aggregate demand
3. Government spending (directly proportional)
4. Investment (directly proportional)

Question 3

Why does an increase in domestic disposable income increase the aggregate demand?

Answer 3

• Home bias: the idea that a representative domestic basket will include imported products, but will place a heavier emphasis on domestic goods
• Although the increase in disposable income also implies an increase in the consumption of imported goods, the increase in domestic consumption is expected to be larger given home bias

Question 4

What is the DD schedule?

Answer 4

Shows the combination of exchange rates and outputs at which the output market is in short run equilibrium
It is upwards sloping because a depreciation in currency is associated with an increase in output

Question 5

What factors shift the DD schedule?

Answer 5

1. Government spending (directly proportional)
2. Investment (directly proportional)
3. Taxes (inversely proportional)
4. Foreign price levels (directly proportional)
5. Domestic price levels (inversely proportional)
6. Demand shift between foreign and domestic goods (inversely proportional)

Question 6

What is the AA schedule?

Answer 6

Shows the combination of exchange rates and outputs that are consistent with equilibrium in the foreign exchange and money market

Question 7

What factors shift the AA schedule?

Answer 7

1. Money supply (directly proportional)
2. Exchange rate (directly proportional)
3. Money demand (inversely proportional)
4. Price levels (inversely proportional)
5. Foreign interest rates (directly proportional)

Question 8

How do temporary policies shift the AA/DD?

Answer 8

Temporary fiscal policies shift the DD whereas temporary monetary policies shift the AA

Question 9

How are permanent fiscal and monetary policies different in the long run?

Answer 9

Permanent fiscal policy has no effect on output because the currency appreciation caused by the policy reduces its expansionary effect on output whereas permanent monetary policy does have an effect on output

Question 10

What happens when expansionary fiscal policy is implemented?

Answer 10

In the short run:
DD will shift to the right 
Expected exchange rates will decrease, so, AA will shift to the left
In the long run:
Price levels won't change

Question 11

What happens when expansionary monetary policy is implemented?

Answer 11

In the short run:
AA will shift to the right
Expected exchange rates will increase so AA will further shift to the right
In the long run:
Price levels will increase in response, leading to a leftward shift of both DD and AA