Output And Exchange Rates In The Short Run Continued Flashcards
What tool is used for monetary policy?
- money supply
What tools are typically used for fiscal policy?
- government spending
- taxation
Describe the effect of a temporary monetary expansion on the AA-DD model?
- increase in the money supply increases the real money supply as prices are sticky
- excess supply of money
- excess demand for bonds
- bond prices increase
- domestic interest rate falls
- demand for domestic currency falls
- demand for foreign currency increased as foreign deposits are now more attractive
- domestic currency depreciates
- E increases
- AA curve shifts up
- at new equilibrium the exchange rate and output is higher
- increase in the exchange rate means real exchange rate must also have increased
- domestic goods become relatively cheaper than foreign goods
- exports increase
- imports decrease
- CA improves
- expenditure increases
- AD increases
- hence, output increases to meet higher demand
Describe the effect of a fiscal policy expansion on the AA-DD model?
- increase in government spending or decrease in taxes increases expenditure in the economy
- this increased AD and output in the short run
- DD curve shifts right
- higher expenditure in the economy increased the demand for real monetary assets
- excess demand for money
- excess supply of bonds
- bond price falls
- domestic interest rate increases
- domestic deposits become more attractive
- demand for domestic currency increased
- domestic currency appreciates
- E falls
Describe how fiscal policy could be used to maintain full employment after a temporary fall in world demand for domestic products
- the fall increases the exchange rate and the reduces output
- the government could implement an expansionary fiscal policy (increasing in G or decrease in T)
- this would return output and the exchange rate to its original level
Describe how monetary policy can be used to restore full employment after a temp. Fall in the world demand of domestic goods
- fall caused the exchange rate to increase and output level to fall
- if the CB increased the Ms (expansionary monetary policy)
- excess supply of money
- excess demand of bonds
- bond price rises
- interest rate falls
- domestic currency depreciated
- E increased
- AA curve shifts up
- Y returns to full employment level
- however, currency is weaker
Describe how monetary policy can be used to restore full employment after a money demand increase
- exchange rate falls as does output
- increase in the Ms (expansionary monetary policy)
- decreases the domestic interest rate
- E rises
- AA curve shifts back and returns to original equilibrium
Describe how fiscal policy can be used to restore full employment after an increase in money demand
- increase causes E and Y to fall
- increase in G or decrease in T (expansionary fiscal policy)
- increases AD
- Y increases
- DD curve shifts right
- output back to full employment level
- increase in expenditure
- increases real money demand
- excess demand for money
- excess supply of bonds
- bond price falls
- interest rate increases
- domestic currency appreciates
- E falls
- under this mechanism currency has strengthened
How do fiscal and monetary authorities create inflationary bias?
- they can create price changes and inflation thereby preventing high output and employment
Describe the short-run effects of a permanent increase in the money supply using the AA-DD curve
- increase in money supply increased real money supply as in the short run prices are stock
- excess supply of money
- excess demand for bonds
- bond price increases
- domestic interest rate falls
- foreign deposits more attractive
- demand for domestic deposits decreases
- foreign currency appreciation
- domestic currency depreciation
- E rises
- because increase is permanent expected E also inc.
- expected rate of return abroad increases
- AA curve shifts up
- new equilibrium - exchange rate and output are higher
- depreciation of domestic currency
- real depreciation of domestic currency
- increase in exports
- decrease in imports
- increase in CA
- expenditure increases
- output increases
- increase in E is much bigger when change is permanent
Describe the long run effects of a permanent increase in the money supply using AA-DD curve
- higher output leads to higher wages and higher priced
- increase in domestic prices reduces the real exchange rate which decreases CA (imports inc. and exports dec.)
- expenditure falls
- output falls
- Upward shift in DD curve
- increase in domestic prices also reduces real money supply
- excess demand for money
- excess supply of bonds
- bond price falls
- domestic interest rate rises
- domestic deposits more attractive
- domestic currency appreciates
- E falls
- AA curve shifts downwards
- at new equilibrium output is lower due to lower demand for domestic goods and services caused by currency appreciation
- long run depreciation is smaller than short run (overshooting)
Describe the effects of a permanent change in fiscal policy
- a permanent increase in government purchases or reduction in taxes
- increased expenditure in the economy
- increases AD
- output increased to meet increased demand
- makes people expect the domestic currency to appreciate
- expected E falls
- this is because increased AD increased RD in the LR
- hence q falls
- currency gets stringers in real and nominal terms
- when expected E falls the expected return abroad falls
- demand for domestic currency increases
- domestic currency appreciated
- Exports fall
- imports increase
- CA worsens
- allows jump to new equilibrium without effecting output
- if change is expected to permanent two effects offset each other so output remains at its full employment level
What effect does the increase in the quantity of monetary assets supplied have on the CA
- increase in real money supppy
- depreciates domestic currency
- increased CA in the SR
What effect does an expansionary fiscal policy have on the CA
- expansionary fiscal policy leads to appreciation of the domestic currency
- decreases CA in the SR
Describe the J-Curve and what it tells us about the trade balance
- when a nominal depreciation occurs this leads to a real real depreciation as prices are stick in the SR
- initially quantity of exports and imports unchanged due to contractual obligations
- but after lag home exports increase due to depreciation
- although quantity of imports not initially affected their price increases due to depreciation of domestic currency
- after lag imports decline
J curve shows that at first trade balance falls due to price effects but after lag quantities adjust and trade balance rises
