Question

 

Suppose a country suddenly faces an unexpected temporary increase in net taxes on households, i.e. T rises temporarily, so disposable income for any given Y drops temporarily. The country has a floating exchange rate for its currency. Use a DD-AA diagram to answer the following (you do not need to show the diagram, but you do need to write in words what happens on it).

a) Indicate and explain any movement(s) of the DD and AA curves that can be observed as a result of this activity.

b) What happens to the exchange rate, E, and national income, Y, as a result? Explain.

Answer 1