# Quiz 17: Output and the Exchange Rate in the Short Run

Business

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: 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.

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: 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.

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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