For each of the following, explain whether the DD and AA curves will shift right, left,...

For each of the following, explain whether the DD and AA curves will shift right, left, or remain unchanged. Explain also the effect on the trade balance.

(a) Investors expect an appreciation of the home currency

(b) Foreign income increases

Solutions

Expert Solution

Factors that are responsible for shifting DD schedule include, Government purchases and Taxes, Investment, Domestic nd foreign price levels, Domestic consumption, etc. This implies that if AD moves up, DD will shift right and vice versa. Factors that are responsible for shifting AA schedule include domestic money supply, Domestic price level, Expected future exchange rate, Foreign interest rate and Shifts in money demand.

a) When investors expect domestic currency appreciation, imports are likely to rise and exports are likely to fall, so there will be downward shift of the AA schedule reflecting a change in the interest parity condition. This will worsen the trade balance as exchange rate falls.

b) This will increase our exports so aggregate demand will shift up. For a given price level, this will shift DD to right. Output will rise and exchange rate will fall. This will worsen the trade balance.

Rahul Sunny answered 1 year ago

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