PS2_solution.pdf - ECO 365 International Monetary Economics...

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ECO 365 - International Monetary Economics Prof. Jordi Mondria Solution Problem Set 2 AA-DD QUESTIONS 1. [15 points] A permanent °scal expansion shifts the DD curve to the right and, because of the e/ect on the long run exchange rate, the AA curve shifts down. The new equilibrium has no e/ect on full employment output, but generates an appreciation of the exchange rate that implies that there is a decrease in the current account. If, instead, there was a temporary °scal expansion of the same size, the AA curve would not shift and the new equilibrium would be at point where output is higher than full employment output and there is a current account deterioration. The current account deterioration under a temporary policy is smaller than the current account decrease under a permanent policy because the currency is less appreciated under a temporary policy than a permanent policy. Thus, a temporary increase in government spending causes the current account to decline by less than a permanent increase because there

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