International Economics Study Set 8

Business

Quiz 16 :

Output and the Exchange Rate in the Short Run

Quiz 16 :

Output and the Exchange Rate in the Short Run

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How does the DD schedule shift if there is a decline in investment demand?
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DD schedule shows the various combinations of output and the exchange rate at which the output market is in short run equilibrium, such that, aggregate demand is equal to aggregate output.
It slopes upward because a rise in the exchange rate causes aggregate demand and aggregate output to rise.
Consider the diagram below:
img Several factors shift the DD schedule.
One such factor is investment demand. Investment demand is a function of interest rate. If the interest rate increases, investment falls as the cost of investment rises.
As such, investment expenditure falls and being a component of aggregate demand, it reduces aggregate demand at a given exchange rate.
Since aggregate demand equals aggregate output, the upward sloping DD schedule shifts towards the left.

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Suppose the government imposes a tariff on all imports. Use the DD-AA model to analyze the effects this measure would have on the economy. Analyze both temporary and permanent tariffs.
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When the government imposes a tariff on all imports, it affects the economy through a change in the aggregate demand.
An imposition of tariff (a tax)on all imports will make imports relatively costlier; import demand falls, consumption demand for domestic goods increases.
Consumption demand being a component of aggregate demand increases the aggregate demand for any level of exchange rate. This change in aggregate demand can be shown by using the DD - AA model.
The following diagram explains the change in the short run equilibrium of the economy due to a change in aggregate demand:
img The short run equilibrium of the economy occurs at point 1, where the output market (whose equilibrium points are summarized by the DD curve)and the asset market (whose equilibrium point are summarized by the AA curve)simultaneously clear. The short run equilibrium levels of the exchange rate and output are E 1 and Y 1.
Now, an increase in the aggregate demand shifts the output market schedule towards the right from DD to DD 1.
If the tariff is temporary, the DD schedule shifts to the right and does not move Aa.Therefore, the output market only changes such that the new DD 1 will intersect the original AA curve.
Thus, the short run equilibrium point shifts from point 1 to point 2. It will lead to exchange rate appreciation from E 1 to E 2 and output increases from Y 1 to Y 2.
If the tariff is permanent, the long run exchange rate appreciates so that the asset market schedule shifts towards the left from AA to AA 1. The intersection of the new DD 1 and AA 1 brings back the economy to the original full employment level of output Y 1 ; the exchange rate appreciates to the extent of E 3.
Therefore, exchange rate appreciation is more in case of permanent tariff, while output remains the same for a permanent tariff.

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Imagine Congress passes a constitutional amendment requiring the U.S. government to maintain a balanced budget at all times. Thus, if the government wishes to change government spending, it must always change taxes by the same amount, that is, ? G = ? T. Does the constitutional amendment imply that the government can no longer use fiscal policy to affect employment and output? (Hint: Analyze a "balanced-budget" increase in government spending, one that is accompanied by an equal tax hike.)
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A balanced budget refers to a budget in which the revenues of the government are equal to its expenditures and there exists neither a budget deficit nor a budget surplus.
The practice of maintaining a balanced budget at all times by the U.S government brings equality between revenue and expenditure.
One must recognize at the outset that it is difficult to interpret correlations between fiscal policies and budget outcomes.
It might happen that a balanced budget might not reduce the relevance of adopting fiscal policy, which is useful to affect the economy's employment and output.
With simultaneous changes in the government expenditure and taxes, a fiscal policy can affect the employment and output of an economy.
When the government increases its expenditure by a dollar through a corresponding equivalent amount of taxation, the aggregate demand increases by less than a dollar as a result. This is explained thoroughly in the next step.
Assume, for a moment, that the value of multiplier in the economy is 'one'.
A dollar increase in taxes will reduce the disposable income (Income after tax)of the consumer by the same amount.
A taxation of $1 on the public cannot reduce the consumer spending by the full extent of a dollar.
This is because the consumption of people depends upon their marginal propensity to consume out of the additional dollar earned.As the disposable income reduces by $1, the consumption will reduce by the amount equal to the marginal propensity to consume which is always between 0 and 1.
Therefore, the aggregate demand will fall by less than a dollar due to an increase in the taxes by $1 if the value of multiplier is kept constant at 'one'.
On the other hand, an increase in government expenditure by $1 will increase the aggregate demand by exactly $1, if the value of multiplier is kept fixed at 'one'.
This means that there will be an increase in the overall aggregate demand by less than a dollar.
Therefore, if a balanced budget is maintained, the government can still use the fiscal policy to affect the unemployment and output/aggregate demand although the effect of the policy is relatively smaller in comparison to a situation when the budget is not maintained.

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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?
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Why does a temporary increase in government spending cause the current account to fall by a smaller amount than does a permanent increase in government spending?
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If a government initially has a balanced budget but then cuts 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?
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You observe that a country's currency depreciates while its current account worsens. What data might you look at to decide if you are witnessing a J-curve effect? What other macroeconomic change might bring about a currency depreciation coupled with a deterioration of the current account, even if there is no J-curve?
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A new government is elected and announces that once it is inaugurated, it will increase the money supply. Use the DD-AA model to study the economy's response to this announcement.
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How would you draw the DD-AA diagram when the current account's response to exchange rate changes follows a J-curve? Use this modified diagram to examine the effects of temporary and permanent changes in monetary and fiscal policy.
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What does the Marshall-Lerner condition look like if the country whose real exchange rate changes does not start out with a current account of zero? (The Marshall-Lerner condition is derived in Appendix 2 under the "standard" assumption of an initially balanced current account.)
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Our model takes the price level P as given in the short run, but in reality the currency appreciation caused by a permanent fiscal expansion might cause P to fall a bit by lowering some import prices. If P can fall slightly as a result of a permanent fiscal expansion, is it still true that there are no output effects? (As above, assume an initial long-run equilibrium.)
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Suppose interest parity does not hold exactly, but the true relationship is R = R * + ( E e ? E )/ E + ? , where ? is a term measuring the differential riskiness of domestic versus foreign deposits. Suppose a permanent rise in domestic government spending, by creating the prospect of future government deficits, also raises ? , that is, makes domestic currency deposits more risky. Evaluate the policy's output effects in this situation.
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If an economy does not start out at full employment, is it still true that a permanent change in fiscal policy has no current effect on output?
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Consider the following linear version of the AA-DD model in the text: Consumption is given by C = (1 - s ) Yand the current account balance is given by CA = aE - mY. (In macroeconomics textbooks, sis sometimes referred to as the marginal propensity to save and m is called the marginal propensity to import.) Then the condition of equilibrium in the goods market is Y = C + I + G + CA = (1 ? s ) Y + I + G + aE - mY. We will write the condition of money- market equilibrium as M s / P = bY - dR. On the assumption that the central bank can hold both the interest rate R and the exchange rate E constant, and assuming that investment I also is constant, what is the effect of an increase in government spending G on output Y ? (This number is often called the open-economy government spending multiplier , but as you can see it is relevant only under strict conditions.) Explain your result intuitively.
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See if you can retrace the steps in the five-step argument on page 174 to show that a permanent fiscal expansion cannot cause output to fall.
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The chapter's discussion of "Inflation Bias and Other Problems of Policy Formulation" suggests (page 170, paragraph 4) that there may not really be any such thing as a permanent fiscal expansion. What do you think? How would these considerations affect the exchange rate and output effects of fiscal policy? Do you see any parallels with this chapter's discussion of the longer-run impact of current account imbalances?
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If you compare low-inflation economies with economies in which inflation is high and very volatile, how might you expect the degree of exchange rate pass-through to differ, and why?
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During the passage of the U.S. fiscal stimulus bill of February 2009, many members of Congress demanded "buy American" clauses, which would have prevented the government from spending money on imported goods. According to the analysis of this chapter, would U.S. government spending constrained by "buy American" restrictions have had a bigger effect on U.S. output than unconstrained U.S. government spending? Why or why not?
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Return to problem above and notice that, to complete the model described there, we must add the interest parity conditions. Observe also that if Y f is the full-employment output level, then the long-run expected exchange rate, E e , satisfies the equation: Y f = ( aE e + I + G ) / ( s + m ). (We are again taking investment I as given.) Using these equations, demonstrate algebraically that if the economy starts at full employment with R = R * , an increase in G has no effect on output. What is the effect on the exchange rate? How does the exchange rate change depend on a , and why? Problem Consider the following linear version of the AA-DD model in the text: Consumption is given by C = (1 - s ) Yand the current account balance is given by CA = aE - mY. (In macroeconomics textbooks, sis sometimes referred to as the marginal propensity to save and m is called the marginal propensity to import.) Then the condition of equilibrium in the goods market is Y = C + I + G + CA = (1 ? s ) Y + I + G + aE - mY. We will write the condition of money- market equilibrium as M s / P = bY - dR. On the assumption that the central bank can hold both the interest rate R and the exchange rate E constant, and assuming that investment I also is constant, what is the effect of an increase in government spending G on output Y ? (This number is often called the open-economy government spending multiplier , but as you can see it is relevant only under strict conditions.) Explain your result intuitively.
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We can express a linear approximation to the interest parity condition (accurate for small exchange rate changes) as: R = R * + ( E e ? E ) / E e. Adding this to the model of problems 14 and 19, solve for Y as a function of G. What is the government spending multiplier for temporary changes in G (those that do not alter E e )? How does your answer depend on the parameters a , b , and d , and why?
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