ECN209

PROBLEM SET 10
SUGGESTED SOLUTIONS

1. Suppose the government temporarily imposes a tariff on all imports. Use

the DD-AA model to analyze the effect this measure would have on the
economy.

ANSWER: A tariff is a tax on the consumption of imports. The demand for

domestic goods, and thus the level of aggregate demand, will be higher for any
level of the exchange rate. This is depicted in figure below as a rightward shift
in the output market schedule from DD to D'D'. If the tariff is temporary, this is
the only effect and output will rise even though the exchange rate appreciates
as the economy moves from point 0 to point 1. If the tariff is permanent,
however, the long-run expected exchange rate appreciates, so the asset
market schedule shifts to A'A'. The appreciation of the currency is sharper in
this case. If output is initially at full employment then there is no change in output
due to a permanent tariff.

2. If a government initially has a balanced budget but then cuts taxes, it is

running a deficit that it must somehow finance. Suppose people think that the
government will finance its deficit by printing the extra money it now needs to
cover its expenditures. Would you still expect the tax cut to cause a currency
appreciation?

ANSWER: A temporary tax cut shifts the DD curve to the right and, in the
absence of monetization, has no effect on the AA curve. In figure 16-3, this is
depicted as a shift in the DD curve to D'D', with the equilibrium moving from
point 0 to point 1. If the deficit is financed by future monetization, the resulting
expected long-run nominal depreciation of the currency causes the AA curve to
shift to the right to A'A' which gives us the equilibrium point 2. The net effect on
the exchange rate is ambiguous, but output certainly increases more than in
the case of a pure fiscal shift.

3. A new government is elected and announces it will increase the money

supply. Use the DD-AA model to study the economy’s response to this
announcement.

ANSWER: The expansionary money supply announcement causes a

depreciation in the expected long-run exchange rate and shifts the AA curve to
the right. This leads to an immediate increase in output and a currency
depreciation. The effects of the anticipated policy action thus precede the
policy's actual implementation.
4. Imagine that the economy is at a point on the DD-AA schedule that is
ABOVE both the AA and the DD curve, where both the asset markets and the
output market are out of equilibrium. Describe graphically and explain what is
the transition to the overall equilibrium of the economy.

ANSWER: In the first place, notice that the nominal exchange rate level E is
high relative to the one that would guarantee equilibrium on the asset markets.
Because it is so high relative to AA, the rate at which is expected to fall in the
future is also high relative to the rate that would maintain interest parity. The
high expected future appreciation rate of the domestic currency implies that the
expected domestic currency return on foreign deposits is below that on
domestic deposits, so there is an excess demand for the domestic currency in
the foreign exchange market. The excess demand for domestic currency leads
to an immediate fall in the exchange rate. This appreciation equalizes the
expected returns on domestic and foreign deposits and places the economy on
the asset market equilibrium curve AA. However, we are still above the DD
schedule, so that there is still excess demand for domestic output (the
exchange rate is still enough depreciated that domestic goods are cheap for
foreigners). As firms raise production to avoid depleting their inventories, the
economy travels along AA, up to a point where aggregate demand and supply
are equal. Because asset prices can jump immediately while changes in
production plans take some time, the asset markets remain in continual
equilibrium even while output is changing.
The exchange rate falls as the economy approaches the equalization of
aggregate demand and production along AA because rising national output
causes money demand to rise, pushing the interest rate steadily upward. Once
the economy has reached equilibrium on DD, aggregate demand equals output
and producers no longer face involuntary inventory depletion. The economy
therefore settles at the only point at which the output and asset markets clear
5. In the context of the DD-AA model, describe graphically and explain what
is the effect of a transitory reduction of taxation on the nominal exchange rate,
output level and current account.

ANSWER: A decrease in the home government taxes increases the home

disposable income, which raises home demand for home goods and raises
home demand for foreign goods. The first effect increases home aggregate
demand but the second effect (which decreases the current account) decreases
home aggregate demand. In the model, we assume the first effect dominates.
So, a decrease in taxes raises aggregate demand and the DD curve shifts to
the right. The rise in aggregate demand leads to an increase in output, an
increase in the money demand, an increase in the home interests rate, and a
fall in the nominal exchange rate.
Under floating rates, the fall in the nominal exchange rate leads to a fall in the
real exchange rate which decreases the current account and decreases
output, offsetting part of the rise in output from the rise in aggregate demand
described above. Overall, output increases because the rise in output due to
the rise in aggregate demand is larger than the fall in output due to the lower
current account. Overall, the current account falls because of three reasons:
1) the rise in imports induced by an increase in disposable income 2) the
decrease in the real exchange rate and 3) the rise in imports induced by the
increase in equilibrium output. In the figure below, after the temporary fiscal
expansion the economy would attain position at point