7.2 Aggregate demand, D Y-D Output, Y The diagram above shows the effects on the

Question

7.2 Aggregate demand, D Y-D Output, Y The diagram above shows the effects on the output market of a change in the real exchange rate (E-P*/P) with no changes in government spending (G), investment (I) or taxes (T) a) From the diagram we can conclude that the real exchange rate must have ncreased/decreased) (1 mark) b) Explain why the change in the real exchange rate which you have identified in answer to part a) led to the changes in demand and output shown in the diagram. (3 marks) c) Can you say whether this change in the real exchange will lead to a movement along a given DD curve for this economy or a shift in that DD curve? Why, or why not? Explain. (2 marks)

Explanation / Answer

a. Real exchange rate must have decreased. That is domestic currency in real terms must have appreciated.

b. An appreciation of domestic currency results in the domestic goods becoming expensive vis-a-vis foreign goods. This decreases the export demand and due to that the overall aggregate demand falls and hence output falls.

c. No, we cannot say with surety whether a change in real exchange rate will lead to a movement or shift in the DD curve. Note that the DD curve is the relationship between exhange rate and the economy's output. If only the exchange rate has caused a change in the real exchange rate then there will be a movement along the DD curve. If the domestic or foreign price level has caused the change in real exchange rate then there will be a shift in the DD curve.

Related Questions

Navigate

• Browse (All)
• Browse 7
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.