340 ch 17

Show the effects of a permanent increase in the money supply.

(1) AA-shifts right-increase in Y and E both higher than if money supply change was temporary rising price level makes AD decrease, DD shifts left (2) rising prices also reduce real money supply, so AA shifts left (although not all the way back to original position) (3) AA and DD reach short run equilibrium at an E that is higher than initially, but lower than the short run effects of the shift. (4) Output returns to initial level because higher prices reversed the effect of the initial depreciation on Aggregate Demand.

A naïve implication of the DD-AA framework is that either fiscal or monetary policy can lead to full employment. Discuss why this view is naïve.

(1) Inflation may arise without any gain in output if the government misuses its power to print money. (2) In practice, it is sometimes hard to be sure whether a disturbance to the economy originates in the output or assets markets. (3) Shifts in fiscal policy often can be made only after lengthy legislative deliberations. Governments are likely to respond to disturbances by changing the monetary policy even when a shift in fiscal policy would be more appropriate. (4) Fiscal policy impacts the government budget and may lead to government budget deficit that must be sooner or later be closed by a fiscal reversal. The state of the electoral cycle may be more important. (5) Policies operate in reality with lags of varying length.

Give 4 examples of situations that would cause the DD-curve to shift to the left.

(1) an decrease in government spending (e.g., decrease in military spending) (2) an increase in taxes (3) a fall in Investment demand (4) a price increase, which would lower net export demand (assuming E and P stay constant) (5) a fall in foreign prices (assuming E and P stay constant) (6) an autonomous fall in consumption demand (as long as it is not entirely a change in import demand) (7) a shift to demanding more foreign goods at the expense of domestic good demand

) In the short run, with prices fixed, how would an increase in government spending affect the DD-AA equilibrium?

) It will increase output and appreciate the currency.

What would be the best description of what we assume about money prices in the short run?

) Money prices of goods and services are only temporarily fixed.

) Imagine that the economy is at a point on that is below both AA and DD, where both the output and asset markets are out of equilibrium. Which first action is TRUE?

) The exchange rate will first rise to a point on the AA schedule.

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

) a decrease in exchange rate, E.

The DD schedule shows all combinations of which 2 variables so that the output market is in equilibrium?

) output and the exchange rate

) In the short-run, a temporary increase in the money supply

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

) If a country's nominal interest rate is zero, then

) the country's economy is in a liquidity trap.

Which of the following compete to determine whether the current account improves or worsens following a rise in the real exchange rate?

) volume effect and value effect

In practice, many U.S. import prices tend to rise by only around

1/2 of a typical dollar depreciation over the following year.

Find the real exchange rate for the following case: Assume that the representative basket of European goods and services costs 40 euros and the representative U.S. basket costs $50, and the dollar/euro exchange rate is $0.90 per euro, then the price of the European basket in terms of U.S. basket is ________.

: [(0.9 $/euro) (40 euro per a European basket)]/[(50 $/U.S. basket)]

Find the real exchange rate for the following case: Assume that the representative basket of European goods costs 150 euros and the representative U.S. basket costs $200, and the dollar/euro exchange rate is $1.20 per euro, then the price of the European basket in terms of U.S. basket is:

: [(1.20 $/euro) (150 euro per a European basket)]/[(200 $/U.S. basket)] = 0.9 U.S. baskets/European basket.

Explain how does a rise in real income affect aggregate demand?

A rise in domestic real income, Y, leads to a rise in disposable income, Yd. This raises the spending on imports, IM, thus lowering the current account, CA, and reducing aggregate demand, AD. However, the rise in Yd also causes a rise in consumption, C, and raises aggregate demand, AD, by more than the corresponding decrease.

What have we assumed when we conclude that a real depreciation of the currency improves the current account?

All else equal and the volume effect outweighs the value effect.

Explain how an increase in government spending would affect the DD-AA schedule in the short run.

An increase in government spending will increase aggregate demand, which will shift the DD to the right. If AA remains unchanged, the new equilibrium will be at a higher Y and lower E. Since E is the nominal exchange rate, a lower E is an appreciation of the currency.

Which one of the following statements is the MOST accurate?

An increase in the real exchange rate and a decrease in disposable income improve the current account.

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.

Current account is given by the equation

CA = EX - IM (measured in terms of domestic output).

What is the real exchange rate? What is its relationship to the current account?

Defined as: EP /P (the exchange rate multiplied by foreign prices, divided by domestic prices). While the nominal exchange rate measures how much of a foreign currency one can buy with a unit of domestic currency, the real exchange rate measures how many goods and services one could buy. A rise in the real exchange rate (a depreciation of domestic currency) means that domestic goods are cheaper compared to foreign goods, so exports increase and imports decrease. Aggregate demand increases and the CA rises. A fall in the real exchange rate has the opposite effect: Aggregate demand decreases and the CA falls.

How does an increase in the real exchange rate affect exports and imports?

Exports increase; imports change ambiguously.

Which one of the following statements is MOST accurate?

Factors of production can be over- or under-employed in the short run.

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.

) The aggregate demand for home input can be written as a function of:

I. Real exchange rate. II. Government spending. III. Disposable income.

What is inflation bias? What measures have governments 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.

Describes the current account balance in short run

Monetary expansion increases the current account balance.

What is the effect of monetary expansion on the current account?

Monetary expansion increases the current account balance.

How is the AA schedule derived?

The AA schedule has a negative slope because an increase in output leads to an increase in the domestic interest rate and a domestic currency appreciation.

What is the AA-curve? Why does it have a negative slope? What factors cause it to shift?

The AA-curve is the specific levels of E and Y under which the money and foreign exchange markets are in equilibrium. The AA-curve has a negative slope because an increase in Y will cause E to fall (a domestic currency appreciation). The factors that affect it are: the money supply, price level, expected exchange rate, foreign interest rates, and the level of real money demand.

Imagine that the economy is at a point that is above both AA and DD, where both the output and asset markets are out of equilibrium. Which first action is TRUE?

The exchange rate will first drop to a point on the AA schedule.

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.

Which of the following is an example of an "unconventional monetary policy" by a central bank?

The purchase of specific categories of assets with new money.

What are two ways the government can use to maintain full employment in an open economy? Also give an example for each.

There are two types of government policy, monetary and fiscal policy. Examples of monetary policy are changes in the money supply. Examples of fiscal policy are changes in government spending or taxes.

Why is the economy at full employment in the long run?

Wages and the price level eventually adjust to full employment equilibrium levels.

) Explain how does an increase in the real exchange rate affect exports and imports?

When the real exchange rate increases, domestic products are cheaper relative to foreign products. Due to this, exports increase as foreigners demand more of our exports. The change in imports is ambiguous because fewer units of imports are purchased (the volume effect), but each foreign unit is now more expensive (the value effect). Remember: exports and imports are measured in terms of domestic output, i.e. dollar value, not volume of units. However, we often assume that the volume effect outweighs the value effect, so that imports decrease when the real exchange rate rises.

How does a rise in real income affect aggregate demand?

Y ↑ implies Yd ↑ implies Im ↑ implies CA ↓ implies AD ↓, but Y ↑ implies Yd ↑ implies C ↑ implies AD ↑ by more.

If the representative basket of European goods and services costs 40 euros, the representative U.S. basket costs $50, and the dollar/euro exchange rate is $0.90 per euro, then the price of the European basket in terms of U.S. basket is

[(0.9 $/euro) (40 euro per a European basket)]/[(50 $/U.S. basket)]

Assume the asset market is always in equilibrium. Therefore a fall in Y would result in

a depreciation of the home currency.

) In the short run, a permanent increase in the domestic money supply causes

a greater upward shift in the AA curve than that caused by an equal, but transitory, increase.

For asset markets to remain in equilibrium, a rise in domestic output must be accompanied by

an appreciation of domestic currency, all else equal.

In the short-run, any fall in EP /P, regardless of its causes, will cause

an downward shift in the aggregate demand function and a reduction in output.

) Which of the following would cause the current account to decrease?

an increase in disposable income

) When the real exchange rate rises

imports measured in terms of domestic output may rise or fall.

Over time, the inflationary pressure that follows a permanent money supply expansion

pushes the price level to its long-run value and returns the economy to full employment.

In the short-run, a temporary increase in money supply

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

Any disturbance that raises aggregate demand for domestic output shifts...

shifts the DD schedule to the right.

A permanent fiscal expansion

shifts the DD to the right and the AA schedule to the left, leaving output the same.

Temporary tax cuts would cause

the DD-curve to shift right.

The current account balance is

the demand for a country's exports less the country's own demand for imports.

The real exchange rate is:

the price of foreign goods in terms of domestic goods.

The real exchange rate, q, is defined as

the price of the foreign basket in terms of the domestic one.

The J-curve illustrates which of the following?

the short-term effects of depreciation on the current account

The interest parity condition requires that:

there is a unique exchange rate for every output level.