Question

Consider an open economy that adopts a flexible exchange rate.

a) suppose a recent study shows that household wealth has increased by 10%. What happens to output and the FC/DC exchange rate in the short run? Explain in words only.

b) Based on your answer in part(a), what happens to country's current account? Explain.

Answer 1

a. Increase in wealth implies an increase in demand and/or increase in purchasing power. This will result in an increase in output. Also, an increase in wealth implies an increase in money supply, that will lower the interest rates in the economy. There will be foreign capital outflow which will cause the domestic currency in terms of foreign currency to depreciate. Hence, the FC/DC exchange rate will decrease in the short run.

?b. The depreciated exchange rate will lead to an increase in exports and a decrease in imports ( because exporters receive higher price and importers have to pay a higher price). Since current account takes into account the net exports and imports (X - M) amongst other things, there will be a current account surplus.