EC3343 Tutorial 5 Suggested Answers

Q1.
Consider the following linear version of the AA-DD model in the text:
Consumption is given by: 𝐶 = (1 − 𝑠)𝑌,
𝑎𝐸𝑃′
and the current account balance is: 𝐶𝐴 = − 𝑚𝑌.
𝑃
In macroeconomics, 𝑠 is referred to as the marginal propensity to save, and 𝑚, the
marginal propensity to import, where 0 < 𝑠 + 𝑚 < 1.
𝑀𝑑
Real money demand is given by = 𝑏𝑌 − 𝑑𝑅.
𝑃
a. Write down the equilibrium condition in goods market, i.e. 𝐷𝐷 curve.
b. Write down the equilibrium condition in both foreign exchange market and domestic
money market, i.e. 𝐴𝐴 curve.
c. Assume that the central bank can hold both the interest rate 𝑅 and the exchange
rate 𝐸 constant, and assuming that investment 𝐼 also is constant. What is the effect
of a unit increase in government spending 𝐺 on output 𝑌 in goods market
equilibrium? (This is the open-economy government spending multiplier.) Explain
your result intuitively.
d. What happens to the size of the government spending multiplier if either 𝑠 or 𝑚 is
increased?

Answers
a. Aggregate demand can be expressed as:
𝑎𝐸𝑃′
AD = C + I + G + CA = (1 − s)Y + I + G + − 𝑚𝑌
𝑃
At short-run equilibrium, 𝐴𝐷 = 𝑌.
Thus, the condition of equilibrium in the goods market is:
aEP ′
Y = C + I + G + CA = (1 − s)Y + I + G + − mY
P
Rearranging, we get the equation of DD curve (goods market curve):
I + G + aEP ′ /P
Y=
s+m
Y is increasing in E, thus DD curve is upward sloping. Note that there is an implicit
assumption here: that is, 0 < 1 − s − m < 1, so that 0 < 𝑠 + 𝑚 < 1.

𝑀𝑑
b. Real money demand is given by: = 𝑏𝑌 − 𝑑𝑅.
𝑃
𝑀𝑑 𝑀𝑠
The equilibrium condition for domestic money market is: = .
𝑃 𝑃

Thus, the equilibrium condition in domestic money market is:

𝑀𝑠
= 𝑏𝑌 − 𝑑𝑅
𝑃
The equilibrium condition in the foreign exchange market is given by the Interest
parity condition (IPC):
(1 + R′ )𝐸 𝑒
1+R=
𝐸
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 Combining the equilibrium conditions in both markets, we get the equation of the
AA curve (asset market curve):
𝑀𝑠 (1 + R′ )𝐸 𝑒
= 𝑏𝑌 − 𝑑 −𝑑
𝑃 𝐸

Y is decreasing in E, thus AA curve is downward sloping.

c. In goods market equilibrium, a 1 unit increase in government spending G will raise

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equilibrium output by . Recall that s is the marginal propensity to save and m is
s+m
the marginal propensity to import. As government spending increases, equilibrium
output increases more than proportionally. This is because if one unit increase in
output demand initiated by the government spending increase output supply by
one unit. This feedbacks into output demand after saving and imports. The
increase in output demand then feedbacks into increase in output supply and starts
another loop… Thus, equilibrium output increases more than one unit.

For example, assuming that government spending increases by $1, total output
increases by $1, then total income increases by $1.
After saving $s and spending $m on imports, total output increases by:
$(1 − s − m).
This addition will feedback into the total income, and total output increases by:
$(1 − s − m)(1 − s − m).
Again, another feedback loop increases total output by:
$(1 − s − m)(1 − s − m)(1 − s − m)…
1
Eventually, total output increases by $ .
s+m
1
(Mathematically, 1 + x + 𝑥 2 + 𝑥 3 + ⋯ = if 0 < 𝑥 < 1.)
1−x

d. If either s or m is increased, the multiplier effect of government spending will be

smaller, as more of that spending is saved (s) or if more of that spending leaves
the country through imports (m).

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Q2.
Draw the shift of the 𝐷𝐷 curve in the following cases:
a. An increase in tax rate 𝑇
b. An increase in investment 𝐼
c. An increase in price ratio 𝑃′/𝑃
d. An increase in foreign disposable income 𝑌 ′ − 𝑇 ′

Answers
a. After an increase in tax rate 𝑇

The shifts of DD are the same for parts (b), (c) and (d), as shown in the diagram
below.

b. As in the lecture, we shall assume that I is exogenous. Thus, an increase in I will

shift the AD curve upwards.

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c. An increase in price ratio P′/P leads to an increase in real exchange rate:
EP′
q= (i.e. a real depreciation). This means domestic goods become relatively
P
cheaper than foreign goods, which leads to an increase in exports and a decrease
in imports. Thus, both current account and aggregate demand increase, and DD
curve shifts to the right.

d. An increase in foreign disposable income 𝑌 ′ − 𝑇 ′ of a trading partner, will result in

an increase in the exports of the domestic country. Thus, this raises the aggregate
demand of domestic products and shifts the DD curve to the right.

Q3.
Draw the graph for both foreign exchange market and money market to determine how
the AA curve shifts in the short run in the following cases:
a. An increase in 𝑀 𝑠
b. An increase in 𝑃
c. An increase in R′
d. An increase in 𝐸 𝑒

Answers
a. For a fixed level of output Y, an increase in the money supply reduces interest rates
in the short run, causing the domestic currency to depreciate (𝑬↑). Holding all else
constant, the 𝑨𝑨 curve shifts up.

b. For a fixed level of output Y, an increase in the level of average domestic prices
decreases the supply of real monetary assets, increasing interest rates, causing
the domestic currency to appreciate (𝑬↓). Holding all else constant, the 𝑨𝑨 curve
shifts down.

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c. For a fixed level of output Y, an increase in the foreign interest rates makes foreign
currency deposits more attractive, leading to a depreciation of the domestic
currency (𝑬↑). Holding all else constant, the 𝑨𝑨 curve shifts up.

d. For a fixed level of output Y, if market participants expect the domestic currency to
depreciate in the future, foreign currency deposits become more attractive, the
expected rate of return for foreign deposit curve shift up, causing the domestic
currency to depreciate (𝑬↑). Holding all else constant, the 𝑨𝑨 curve shifts up. The
graph is the same as in part (C).

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Q4.
Suppose the economy is initially at equilibrium, at the full employment level. Assume
there is an exogenous and permanent increase in the real money demand for domestic
currency from 𝑳𝟏 (𝑹, 𝒀) to 𝑳𝟐 (𝑹, 𝒀) .
a. Explain graphically and intuitively how this would shift the 𝑨𝑨 curve, and how this
would change the equilibrium output and exchange rate in short-run equilibrium.
b. Explain graphically and intuitively what fiscal policy would restore the output to the
original level, and its effect on exchange rate.
Answers
a. After an exogenous and permanent increase in the real money demand, the real
money demand curve shifts out from 𝑳𝟏 (𝑹, 𝒀) to 𝑳𝟐 (𝑹, 𝒀) , which leads to an
increase in increase in interest rate from 𝑹𝟏 to 𝑹𝟐 , a currency appreciation from 𝑬𝟏
to 𝑬𝟐 and further appreciation from 𝑬𝟐 to 𝑬𝟑 due to the change in expected
exchange rate. Thus, 𝑨𝑨 curve will shift from 𝑨𝑨𝟏 to 𝑨𝑨𝟑 . Note that if this change
is only temporary, people do not change their expectation on exchange rate, and
𝑨𝑨 curve will only shift to 𝑨𝑨𝟐 . In the equilibrium, exchange rate appreciates from
𝑬𝟏 to 𝑬𝟑 , and output decreases from 𝒀𝑭 to 𝒀𝟑 .

b. We can boost the economy back to full-employment level by fiscal expansion (𝐺↑
or 𝑇 ↓ ). For example, an increase in government expenditure 𝐺𝐺 will raise
aggregate demand and shift the 𝑫𝑫 curve from 𝑫𝑫𝟏 to 𝑫𝑫𝟐 , thus restoring the
equilibrium output from 𝒀𝟑 to 𝒀𝑭 . Moreover, the fiscal expansion further
appreciates the exchange rate from 𝑬𝟑 to 𝑬𝟒 .