Question

4. Do you agree with the following statement: “A real depreciation of home currency always improves the trade balance.” Why/why not?

5. How does a rise in real income affect aggregate demand? (a) Y ↑→ Yd ↑→IM ↑→CA ↓→AD ↓, but Y ↑→ Yd ↑ → C ↑→ AD ↑ by more

(b) Y ↑→ Yd ↑→IM ↓→CA ↓→AD ↓, but Y ↑→ Yd ↑→ C ↑→ AD ↑ by more

(c) Y ↑→ Yd ↑→IM ↑→CA ↑→AD ↑, and Y ↑→ Yd ↑→ C ↑→ AD ↑

(d) Y ↑→ Yd ↑→IM ↑→CA ↓→AD ↓, but Y ↑→ Yd ↑→ C ↑→ AD ↑ by less

(e) Y ↑→ Yd ↑→IM ↓→CA ↓→AD ↓, but Y ↑→ Yd ↑→ C ↑→ AD ↑ by less

Answer 1

4) I agree with the statement that real depreciation always improves trade balance

Trade balance is the difference between total exports and total imports.

When the currency depreciates, domestic goods become cheaper compared to foreign goods both to residents and foreign residents. This implies that exports increases and imports fall. This improves the trade balance.

5) a is correct

Increase in real income increases disposable income. This has two effects.

One is this leads to increase in demand for imports which reduces aggregate demand. This worsens current account due to rise in imports.

Another is increase in disposable income leads to increase in consumption spending which increases aggregate demand.

The second effect is larger than first effect. So aggregate increases in total.