Question

Explain the effect of an increase in exports on the equilibrium output and inflation in the AD-AS model. Carefully distinguish between the short-run and the long-run equilibrium. Would this affect the potential output? Why/Why not?

Answer 1

AD-AS MODEL

Is an economic model that explains price level and output through the relationship of aggregate demand and aggregate supply.According to this model an economy achieves equilibrium when AD=AS,AD being the aggregate demand and AS being the aggregate supply.

effect of an increase in exports

1. on the equilibrium output-When exports in an economy increases, employment increases, more raw material is purchased and more investment is done to meet rise in demand. which results in Income and employment in our economy increasing leading to  increase in Aggregate demand in our economy .Graphically there is a rightward shift of ad curve.If Aggregate Demand increases while Supply remains the same then prices will naturally rise,So currently the economy is AD>AS in short run.But as price increases supply also starts increasing,which will eventually reach an equilibrium higher than the previous one,inshort in the long run increase in export increases equilibrium output.
2. inflation-Increase in export will have an inflationary effect because of the change of economic status to AD>AS in short run as discussed above , also an increase in exports leads to increased demand for domestic currency in international foreign exchange market since exporters are to be paid in domestic currency by foreign importers,As a result there also comes an appreciation of currency which will make the domestic currency strong  a strong domestic currency hampers exports and makes imports cheaper. as a result there is an increase in supply which will lead to decrease in inflation rate in the long run.

potential output

Potential output will increase if there is an increase in export because as discussed earlier an increase in export will lead to generation of more employment which also means more utilisation of man power growth in the size of the working population enables an economy to increase its potential output,Another reason is that increase in export will have a positive impact on the economy of a country which will result in better technology,better health care,better facilities etc,ALL this will help in increasing the potential output of a nation.