Question

1. What factors cause real exchange rate to rise? What does real exchange rate appreciation (depreciation) imply for net exports? Why? (With appreciation, NX falls. With depreciation, NX rises)

2. What is purchasing power parity (PPP)? The law of one price? What should be real exchange rate if PPP holds? What should determine nominal exchange rate if PPP holds? Does PPP hold in practice? (No) Why? (not all goods are easily traded; even tradable domestic and foreign goods might not be perfect substitutes)

3. Aggregate Demand curve (AD curve). What determines aggregate demand? (Y=C+I+G+NX) What is the shape of AD curve? Why is it downward sloping? (Because of Wealth effect, interest rate effect and exchange rate effect). When does AD curve shift? (When C, I, G or NX changes for any given price level)

4. Long run aggregate supply curve. Determinants of long-run aggregate supply and the shape of long run aggregate supply curve (LRAS curve). When does the LRAS curve shift?

5. What equation shows short run aggregate supply? What is the shape of Short run aggregate supply curve (SRAS curve)? What theories explain the shape of SRAS curve? (Sticky-wage theory, sticky-price theory, misperceptions theory). Discuss each theory. When does SRAS curve shift?

6. How do we find long-run equilibrium? (at the intersection of AD and LRAS curves). How do you find short-run equilibrium? (At the intersection of AD and SRAS curves).

Answer 1

Answer to Question 1)

Real Exchange rates, refer to the price of one currency in terms of another. This is used as a benchmark for trade among both the nations. A change in real exchange rates has a huge impact on the overall trade in goods and services. For example, if the real exchange rate falls, we then need more money to exchange an equivalent currency of foreign denomination. This makes imports relatively expensive.

For example, if dollar appreciates in comparison to yen (Chinese Currency), then more yen would be required for making payments as conversion would give lesser number of dollars.

The reasons for appreciation of a currency are as follows: -

1) If the government debt is in control, it means that interest payments need not be made by the government and tax revenue increases. Foreign companies like to invest in countries wherein the government debt is low as their rate of return is higher in these countries. This makes their currency appreciate in value

2) If the country sees an increase in exports of goods and services, the demand for the local currency is more. This leads to an appreciation in value. The reason why countries such as United States see appreciation in value of dollar with respect to other countries is simply because their net exports are extremely high.

3) If the inflation rate in a country is lower as compared to other countries, it indicates stability and sound investment keeps pouring in which leads to appreciation in currency value.

4) Interest Rates is another major component. As interest rates remain lower, the demand for goods and services is high. Companies prefer to invest in such countries as loans are available at a lower rate and therefore, the interest payments are low. As foreign companies come in domestically to invest the currency appreciates in value.

5) Political and Economic Stability is another consideration which appreciates the value of domestic currency. This is because as a country exhibits stability, the value of its currency rises.

Implications for net exports: -

As the value of currency rises, the net exports and their corresponding value also increases. This is because it becomes expensive for other countries to be able to import from them. For example, countries such as the United States of America see increased returns, primarily because their currency expands and exports bring in more money for the nation.

Please feel free to ask your doubts in the comments section.