ECON 2181 Week 5 Quiz

Aggregate demand

The total quantity of goods and services that households, firms, government, and foreign buyers want to purchase at various income levels.

Components of aggregate demand

Consumption, investment, government spending, and the current account (net exports).

Consumption spending determinants

Primarily depends on disposable income (income after taxes); as disposable income rises, spending increases but by a smaller proportion.

Influence of real interest rates on consumption

Higher real interest rates encourage saving and discourage consumption.

Influence of wealth on consumption

Increased household wealth tends to raise consumption, though in short-run models the effect is assumed minor.

Determinants of the current account

Real exchange rate (relative prices of domestic vs. foreign goods) and disposable income (which affects imports).

Effect of higher real exchange rate on trade

Makes domestic goods cheaper relative to foreign goods, boosting exports and reducing imports, improving the current account.

Value effect

Immediate impact of exchange rate changes on the price of traded goods, before quantities adjust.

Volume effect

Gradual adjustment of import and export quantities in response to exchange rate changes; dominates over time.

Effect of disposable income on the current account

Higher disposable income raises spending on imports, worsening the current account.

Goods market short-run equilibrium condition

Occurs when the level of production equals the total desired spending on goods and services.

Purpose of the DD schedule

Shows all combinations of output and exchange rate where the goods market is in short-run equilibrium.

Shape of the DD curve

Upward sloping because a weaker domestic currency increases demand for domestic goods, raising output.

Movement along the DD curve

Results from changes in the exchange rate.

Rightward shift of the DD curve

Occurs from higher government spending, investment, or consumption; lower taxes; or lower domestic prices relative to foreign prices.

Leftward shift of the DD curve

Occurs from reduced spending, higher taxes, or higher domestic prices relative to foreign prices.

Markets behind the AA schedule

Foreign exchange market and money market.

Condition for foreign exchange market equilibrium

Domestic interest rate equals the foreign rate plus expected depreciation of the domestic currency.

Condition for money market equilibrium

The real money supply equals real money demand.

Shape of the AA curve

Downward sloping because higher output raises money demand and interest rates, which cause the domestic currency to appreciate.

Upward (rightward) shift of the AA curve

Caused by an increase in money supply, higher foreign interest rates, lower domestic money demand, or higher expected future depreciation of the domestic currency.

Downward (leftward) shift of the AA curve

Caused by higher domestic prices or lower foreign interest rates.

Intersection of DD and AA curves

Represents the short-run equilibrium where goods, money, and foreign exchange markets are all simultaneously in balance.

Short-run target of monetary policy

The quantity of monetary assets, which influences interest rates and exchange rates via the asset market.

Effect of a temporary monetary expansion

Lowers interest rates, depreciates the domestic currency, raises aggregate demand and output; shifts the AA curve upward.

Short-run target of fiscal policy

Government purchases and taxes, which directly affect demand for goods and services.

Effect of a temporary fiscal expansion

Increases demand and output; shifts the DD curve rightward; raises interest rates and causes currency appreciation.

Limitations of demand management policies

Implementation lags, data uncertainty, inflationary pressures, and political constraints can reduce effectiveness.

Difference between temporary and permanent policy changes

Permanent policies alter expectations about future exchange rates, affecting current behavior in goods and asset markets.

Effect of a permanent monetary expansion

Causes a stronger currency depreciation because people expect further depreciation; the AA curve shifts up more than in a temporary case.

Long-run result of a permanent monetary expansion

Wages and prices rise, restoring real balances and returning output to its normal (potential) level.

Effect of a permanent fiscal expansion

Initially increases demand but leads to currency appreciation that offsets net exports; long-run output remains unchanged due to full crowding out.