ECON335 Assignment 2 (Due 5pm Tuesday, Apr 16, at the beginning of the class) All answers should be typed or neatly handwritten. Assignment should be no more than 5 pages. 1. The short-run equilibrium in the output market is achieved when the value of income from production (output) Y equals the value of aggregate demand D, which is a function of the real exchange rate, disposable income, investment expenditure and government purchases, i.e., Y = D(EP*/P, Y-T, I, G). The DD schedule shows combinations of output and exchange rate at which the output market is in short-run equilibrium. a) Why does the DD schedule slope upward? b) List the factors which can shift the DD curve rightwards. 2. The AA schedule shows combinations of output and exchange rate at which two asset markets, namely the foreign exchange market and the money market are simultaneously in short-run equilibrium. a) Why does the AA schedule slope downwards? b) Consider an increase in the domestic money supply. What is the effect on nominal exchange rate? Has the output changed? What happens to the AA schedule? c) What other factors can cause a rightward shift in the AA schedule? 3. With the aid of an appropriate diagram, explain how a central bank keeps its exchange rate fixed at E0 under a fixed exchange rate regime when output increases. 4. Define devaluation and use the DD-AA model to show the effect of a currency devaluation on the economy. What are the possible reasons for governments choosing to devalue their currency?