Consider an economy which we call Home Economy and is in equilibrium. Let domestic consumption be:
C = c x (Y-T)
And the Current account be:
CA= CA + ax(ExP*/P) - xxcx (Y-T)
Where c, x are constants ∈ (0,1) (c is the marginal propensity to consume and x is the share of imports out of private consumption). CA + ax(ExP*/P) are the exports and x x c x (Y-T) are the imports. CA is a constant, a is a positive constant, E the exchange rate, P* the price level in the Foreign economy and P the price level in the Home economy. Y is production and T are taxes. Government expenditures and Investment are exogeneous and called G and I, respectively.
1. Write an expression for the DD curve. This should be an expression with Y on the left-hand side and E, as well as other variables (G,I, P*, P) and parameters (c,x,a), on the right-hand side. Is the relation between Y and E positive or negative?
Money demand in the Home economy is given by: L = sxY - bxR, where s and b are positive constants.
2. Using the equilibrium condition between money demand and money supply, as well as the interest parity condition, please derive an expression for the AA curve. This should be an expression with Y on the left-hand side and E as well as other variables (M³, P, R*, Ee) and parameters (s, b) on the right-hand side. Is the relation between Y and E positive or negative?
3. Suppose the government of the Home Economy decides to implement an austerity program: it raises taxes (T) and reduces government expenditures (G). Show the effect of this policy in a diagram with the AA and DD curves. Explain which curves are moving and why. What happens to production (Y)? Does the exchange rate appreciate or depreciate? You do not need to derive / calculate anything in this question, just show the effects on the diagram and explain in words. Can you give an example of a country that implemented this sort of austerity measures in the recent history?
