Question

a)Using the AD-ERU and the WS-PS diagrams and assuming the real wage is
W/P, explain the effects on the real wage, the real exchange rate and output
when there is:-
(i) a decline in tax wedge
(ii) an expansionary of fiscal policy

(b) A small and open economy which practices a flexible exchange rate system has
experienced a permanent positive aggregate demand shock due to a drastic increase in export. Based on this situation, draw the PC-MR, the IS-RX, and the AD-ERU diagrams to explain the path back to medium-run equilibrium (MRE).

Answer 1

a) i) When there is a decline in tax wedge, real wage rises. The real exchange rate and output also rises

ii) When there is an expansionary fiscal policy real wage unchanged, real exchange rates fall but output rises.

b) When an economy experiences a permanent positive aggregate demand shock, the IS curve shifts to the right, but the central bank will try to regain the Medium-Run Equilibrium (MRE) through a dynamic adjustment process.

Explanation:

a) i) Tax Wedge is defined as the difference between real consumption wage and real product wage. When there is a decline in tax wedge then it implies that the real product wage is higher than the real consumption wage, the workers will be better off. So, the real wage increases and the Price Setting (PS) curve will shift upwards. Hence, employment increases (N) and unemployment fall (U).

As a result of an increase in employment, the ERU (Equilibrium Rate of Unemployment) will shift to the right in the AD-ERU space. So, the output will increase in overall and the real exchange rate also rises (in short and medium-term where the inflation rate is either constant or rising at a lesser rate) because with the increase in employment and wages the home goods become costlier and it can occur when the real exchange rate is higher

ii)) When there is an expansionary fiscal policy (either reduction of a tax cut or the increase in government expenditure).There will be no such change in the WS-PS space but in the AD-ERU space, the AD curve will shift to the right as a result the output(Y=C+I+G+NX) will increase and the real exchange rate will fall because the home goods are now cheaper as with same wage rate they are producing more, cost of production falls export rises and it can only be possible when the real exchange rate falls

b) Consider a permanent positive aggregate shock in demand, then the immediate effect will be on the IS (Investment-Savings) Curve. The IS curve will shift to the right from IS0 to IS1 in the IS-RX plane. To reback to the medium run equilibrium as before a dynamic adjustment has to make. This is explained through 3 intervals of time.

At Period 0:-

When there is a positive aggregate shock in demand then the IS curve shifts to the right output rises. But, the central bank will not immediately predict the change in r (point B is not on the MR curve). They will predict in the first period (π1=r0). Based on that the Central bank locates the point E0 on the MR curve. Based on that they will set the point (r=r0). Now, the foreign exchange market foresees the central banks' decision and they will appreciate the exchange rate and θ rises initially and depreciates.

At period 1

Now, the central bank wants to reestablish the medium-run equilibrium. Hence, the Central bank will increase the interest rate as a result the expected inflation rate with one period lag also increases(π2=r1) and the Investment falls. Again, the foreign exchange market foresees the central bank decision and they will reduce the ERU curve to the left such that the home currency appreciates and the net export falls, output also falls. And, this process will continue to occur until and unless the rate of interest regains with the world rate of interest(r*)