PROBLEM SET #4 1) Explain how does an increase in the real

1) Explain how does an increase in the real exchange rate affect exports and imports?
2) True, False Explain: Monetary expansion causes the current account balance to increase in
the short run.
3) Find the real exchange rate for the following case: Assume that the representative basket of
European goods costs 100 euros and the representative U.S. basket costs $125, and the
dollar/euro exchange rate is $0.75 per euro, then the price of the European basket in terms of
U.S. basket is:
4) Give 4 examples of situations that would cause the DD-curve to shift to the left.
5) Imagine that the economy is at a point on the DD-AA schedule that is above both AA and DD
and where both the output and asset markets are out of equilibrium. Explain what will happen
6) Using a figure show that under full employment, a temporary fiscal expansion would increase
output (over-employment) but cannot increase output in the long run.
7) 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.
[Diagram required]
ii) Both the temporary and permanent expansionary fiscal policy improves 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. [Diagram required]
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