PROBLEM SET #4
True, False Explain:
i)
Monetary expansion causes the current account balance to increase in the short run.
ii)
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. [Diagram required]
iii)
Both the temporary and permanent expansionary fiscal policy improves the current
account balance. [Diagrams required]
iv)
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. [Diagram required]
Short Answers
1) Explain how does an increase in the real exchange rate affect exports and imports?
2) Give 4 examples of situations that would cause the DD-curve to shift to the left.
3) Imagine that the economy is at a point on the DD-AA schedule that is above both AA and DD
(but less than equilibrium output) and where both the output and asset markets are out of
equilibrium. Explain what will happen in this economy to get equilibrium exchange rate and
output
ANALYTICAL QUESTIONS:
4.
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.
(i) an increase in home money supply
(ii) a decrease in home government taxes