Question

Using the Aggregate Demand-Aggregate Supply graphical analysis, show what happens in the short and long-run if the exchange rate appreciates. What happens to NX (exports-imports)? Start your analysis in Long Run equilibrium and label this point A. Describe the adjustment back to the Long Run equilibrium.

Answer 1

Whenever currency appreciates, it causes imports to become cheaper and exports to become costlier .

Hence total imports are increased and exports decrease. Thus NX decreases because imports increased.

Due to rising imports, local employment takes hit and hence aggregate demand shifts from AD0 to AD1. Inflation to decreases from P0 to P1 and output falls to Y0 to Y1.

Due to appreciation in currency, the equilibrium shifts from A0 to B1 as shown in graph.

The original equilibrium returns when currency depreciates again raising exports and NX both and reduce imports.