Problem Set #5


Problem Set # 5

True, False or Uncertain: Explain


(i) In an open economy DD-AA model, a permanent increase in domestic government purchases leads to an increase in domestic equilibrium interest rate and output, and results into a depreciation of domestic currency against foreign currency in the short run.

(ii) Both the temporary and permanent expansionary fiscal policy raises the current account balance. [Diagrams required]

(iii) If the economy, which is under a flexible exchange rate system, starts at long-run equilibrium, a permanent tax cut will cause its currency to appreciate but will have no effect on output in the short-run.



Consider the model of output and exchange rate determination (the AA-DD model) we have studied in class. Suppose the economy begins at its long-run level with output at its fullemployment level. Compare and contrast the short-run effects of the following temporary policies by the home government: listed below on home output, the home current account, and the nominal exchange rate.

Use AA-DD-XX diagrams to support your answers. (slides 50-55 should help with the XX curve)

(i) an increase in home money supply

(ii) a decrease in home government taxes


Imagine the economy is at a point on the AA-DD diagram which is below both the

DD schedule and the AA schedule but output is greater than equilibrium output. Explain what will happen next?