Question

5. You work for Dr. Zhang, the autocratic dictator of Zhouland. After taking an economics course, you decide that devaluing (i.e., making less valuable) your currency (Zhoullars) is the way to increase GDP. Following your advice, Dr. Zhang orders massive increases in the supply of Zhoullars, which reduces the value of Zhoullars in world markets. Use the AD-AS model to determine the effects on real GDP, unemployment, and the price level in Zhouland in both the short run and the long run. Assume the economy was in long-run equilibrium before this change and consider only this stated change.

Answer 1

A fall in value of Zhoullars will depreciate the Zhoullar, which will make exportable goods more competitive in global market, and imported goods costlier. Therefore, export demand will rise and import demand will fall, increasing net exports and increasing aggregate demand. The AD curve will shift rightward in short run, increasing both price level and real GDP and causing an inflationary gap in short run. In long run, higher price level increases input costs, so firms lower production, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and eliminating inflationary gap.

In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with long-run equilibrium price level P0 and real GDP (= Potential GDP) Y0. Higher aggregate demand will cause the AD curve to shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with inflationary gap being equal to (Y1 - Y0) in short run. In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.