Question

According to the Wall Street Journal, the value of U. S. dollar relative to the value of foreign currencies has significantly risen since the last election. Assuming that the economy is currently in the long-run macroeconomic equilibrium, use the AD-AS model and analyze how an increase in the value of U.S. dollar will affect the U.S. economy. In each case, be sure to label the initial equilibrium and new equilibrium including the equilibrium price and equilibrium GDP.

a. Draw a basic AD and SRAS graph (with LRAS constant) showing the economy in the long-run equilibrium. (2pts)

b. How does it change the short-run macroeconomic equilibrium? Briefly explain and illustrate it on your graph. (2pts)

c. How does the economy adjust back to long-run equilibrium? Briefly explain and illustrate it on your graph. (2pts)

Answer 1

Ans.

a) Suppose the economy is in equilibrium with full employment level of output Y and price level P having aggregate demand AD, short run aggregate supply SRAS and long run aggregate supply LRAS.
b) An increase in value of U.S. dollar makes exports from U.S. expensive for other countries and inports from other countries cheaper for U.S., so, demand for U.S. exports fall but demand for imports in U.S. increases. Thus, net exports in U.S. falls. This leads to fall in aggregate demand for goods and services in the economy shifting aggregate demand curve leftwards from AD to AD'. This creates a situation of excess supply in the market decreasing price level from P to P' and output level from Y to Y'.
c) In long run, a decrease in price level makes firms to revise their expectations of price level downwards and as price of inputs will fall, so, cost of production will decrease increasing aggregate supply shifting short run aggregate supply curve to right from SRAS to SRAS'. This leads to a decrease in proce level from P' to P" but will increase output back to full employment level, Y.

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