Economics temporary increase in investment demand:
1. Suppose instead there is a temporary increase in investment demand, such as the one that occurred in the U.S. during the 1990’s and 2000. Use the DD-AA model to answer the following questions.
(a) For a given real exchange rate, use the goods-market diagram (the one with an aggregate demand curve) to show how the change in investment changes the equilibrium Y. (As explained in class the nominal exchange rate is a fixed proportion of the real exchange rate in the short-run, since price levels do not change.)
(b) Using your answer for (a), show how the DD curve shifts.
(c) How does the AA curve shift? Explain.
(d) Using your answers to (b) and (c), show in a DD-AA diagram how equilibrium output Y and the exchange rate E change.
2. Suppose that the U.S. government passed a constitutional amendment requiring the government budget to be balanced at all times.
In terms of the notation from class and the text, G = T, which means that any changes in government spending G and taxes T must be equal. Does this mean that the government can no longer use fiscal policy to affect employment and output? Answer this question in the following steps.
(a) For a given real exchange rate, use a goods-market diagram to show how temporary identical increases in G and T change Y. (Hint: What do we know about the marginal propensity to consume out of disposable income, Y – T?)
(b) Using your answer for (a), show how the DD curve shifts.
(c) How does the AA curve shift? Explain.
(d) Using your answers to (b) and (c), show in a DD-AA diagram how the balanced-budget increases in G and T affect output Y in the short-run. Also show how the exchange rate E changes.
3. A new government is elected and announces that once it is inaugurated, it will increase the money supply. What is the economy’s response to this announcement? Answer this question in the following steps.
(a) Use our foreign-exchange-market and money-market diagrams (the ones that share the same horizontal axis) to show how the increase in the future money supply will affect the future exchange rate. (Hold output Y fixed for both (a) and (b).)
(b) Your answer to (a) tells you how the future increase in the money supply affects the current expectation of the future exchange rate (the “expected future exchange rate,” Ee). Use another set of foreign-exchange-market and money-market diagrams to show how this change in expectations affects the current exchange rate. Note: There is no change in the current interest rate. (Recall a similar question on a previous problem set.)
(c) Using your answer to (b), show how the AA curve shifts. Is there any shift in the DD curve? Explain.
(d) Using your DD-AA diagram, show how the new government’s announcement affects current output Y and the exchange rate E.
4. Suppose that there is a permanent fall in private domestic demand for a country’s output (a fall in C, causing a downward shift of the entire aggregate demand schedule). What is the effect on output in the short-run? Answer this question in the following steps.
(a) How does the DD curve shift? Explain.
(b) In class, we analyzed a permanent fall in taxes T, which caused a permanent increase in the aggregate demand schedule. Using the same type of analysis, show how the AA curve shifts.
(c) From your answers to (a) and (b), how does output change? Based on your answer, what should the government’s response be to this permanent fall in private aggregate demand?