International Finance

Class Assignment Chapter 16 –Output and the Exchange Rate in the Short-run

Question 4: Suppose there is a permanent fall in private aggregate demand for a country’s output (a downward shift of the entire aggregate demand schedule). What is the effect on output? What government policy response would you recommend?

AA2

AA1

A permanent fall in private aggregate demand (downward shift of the aggregate demand schedule) DD curve shifts to the left from DD1 to DD2

Given a permanent fall in private aggregate demand, people expect a fall in the relative demand for domestic output → expect a real depreciation of domestic goods → a higher expected future exchange rate Ee will cause an outward shift of the AA, other things equal.

The DD shifts left and AA shifts right simultaneously, leaving output unchanged.

It is not necessary for the Government to conduct any policy because the output is at full-employed level (the policy should take place if the output is above or below the full-employed level)

Question 6: If a Government initially has a balanced budget but then cut taxes, it is running a deficit that it must somehow finance. Suppose people think the government will finance its deficit by printing the extra money it now needs to cover its expenditures. Would you still expect the tax cut to cause a currency appreciation?

Initial time:
Government has balanced budget and then cut taxes increase disposal income and consumption aggregate demand increases Output expansion - DD curve shifts to the right from DD1 to DD2 new equilibrium point – point 2 with higher output (Y2>Y1) and lower exchange rate (E2<E1) (appreciation of domestic currency)

In the future:
The Government will finance its deficit by printing the extra money increase real money supply decrease domestic interest rate increase exchange rate to point 3 (depreciation of domestic currency) AA curve shifts to the right from AA1 to AA2 new equilibrium point – point 3 with