Question

Suppose that the central government decides to try and temporarily increase domestic investment spending by relaxing various domestic investment regulations for six months. Use the DD-AA model as discussed in the textbook to answer the following questions: (a) What will be the short-run consequences of this policy change? Briefly explain. (b) What effect will this policy change have on the domestic current account? Briefly explain. (c) How does your analysis in part (a) change if this policy change is made permanent?  

Answer 1

(a) The central government's decision to temporarily increase domestic investment spending levels in the economy would initially lead to an increase in the aggregate demand(AD) in the goods and services market in the economy, holding everything else constant. An increase in AD signifies an upward shift in the AD curve in the graphical model of the goods market resulting in an increase in real output or real income in the economy as well. This expansionary effect on the AD due to an increase in the investment spending by the government can be sequentially translated to the DD-AA graphical model through a rightward or outward shift of the DD curve resulting in an increase in the real aggregate output or income in the economy in the short-run. As a consequence of higher aggregate output level or income level, the demand for money holdings or the loanable funds increases in the money or loanable funds market in the domestic economy thereby, increasing the domestic interest rate and consequently increasing the value of the domestic currency relative to foreign currencies or causing appreciation of the domestic currency, again considering all the other relevant or concerning factors as constant.

(b) Now as the exchange rate value of the domestic currency increases or in other words, as the domestic currency appreciates relative to other foreign currencies due to the rightward or outward shift of the DD curve in the DD-AA graphical model and increase in the real aggregate output or income, the value of the domestic goods, services, and assets would now become more expensive to the residents of the rest of the world thereby reducing the demand for domestic goods, services, and assets in the international market. This would cause a reduction in the overall export level by the domestic country. On the other hand, due to domestic currency appreciation, the value of foreign goods and services has now become relatively cheaper for the residents of the domestic country which would increase the overall demand for imports and the overall import level of the domestic country as well. Therefore, an increase in the overall import level and a decrease in the total export level of the domestic country would result in the reduction or contraction of the net trade balance of the domestic country leading to a decrease or reduction in the current account balance as well, considering everything else as constant.

(c) A permanent increase in the domestic investment spending by the central government will potentially affect the expected exchange rate of the domestic country in the long run and would have no impact on the real aggregate output or income level of the country. As the DD curve shifts to the right or outward in the short-run due to an increase in government investment spending, the AA curve would eventually shift to the left or inward thereby restoring the real output or income of the domestic country to its original or fixed position. It would potentially cause a long-term and permanent domestic exchange rate increase in the future which would offset the temporary or short-run impact of the increase in domestic investment spending on the AD in the domestic goods market. Therefore, furthermore, the overall export and import level of the domestic country will also adjust gradually with long-term and permanent changes in the domestic exchange rate, and the trade account balance would also adjust accordingly in the long run thereby, consequently stabilizing or adjusting the domestic current account balance as well. Note that the long-term or permanent appreciation of the domestic currency would still continue to reduce or decrease the domestic trade balance and the current account balance but the magnitude of the current account would decrease gradually as both the overall export and import level of the country adjusts gradually according to the long-term domestic exchange rate changes. Hence, the real aggregate output or income level is restored to its original or initial position in the long-run offsetting the short-run effects of the government policy and the overall current account balance of the domestic country would gradually adjust or improve in the long-run in conjunction with long-term and permanent changes in the domestic exchanger rate thereby offsetting or partially compensating for the initial reduction or decrease due to the temporary impact of an increase in government investment spending in the short-run.