Question

Suppose prior to the coronavirus pandemic, the United States (U.S.) was in a long-run equilibrium initially with a floating exchange rate regime. The coronvirus pandemic caused many local businesses, shops, and restaurants to close, decreasing consumption demand for domestic goods and services temporarily.

a. (3 Points) Use the AA-DD-XX diagram to determine what happens to output, the spot exchange rate, and the current account in the U.S. as a result of the decrease in consumption, all else equal. Is the resulting equilibrium above or below the current account target?

Answer 1

The resulting equilibrium will be below the current account target. Due to the reduction in consumption, demand falls and the demand curve shifts downward from DoDo to D1D1. This creates excess supply situation in the economy. As a result, price falls and production subsequently reduces. Hence, total output decreases thus creating a new equilibriium E1 with Price P1 and output Q1(shown in the diagram). Prior to the pandemic, market equilibrium was E0 with price P0 and output Q0 ( also shown in diagram). As for spot exchange rate, it will also fall becouse transcation in foreign currencies decreases which keads to the redcution in the demand of foreign currency. Thus, spot exchange rate falls. Also there will fiscal deficit due to which the balance in current account will fall.