A rise in p makes domestic goods more expensive rer

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° A rise in P makes domestic goods more expensive (RER appreciates), leading to lower aggregate demand = ) DD curve shifts left. ° A rising price level also reduces the real money supply over time = ) AA curve moves left ° AA and DD stop shifting when they intersect at the full employment level. ° At the new equilibrium, E; E e ; and P have risen in proportion to M s increase, consistent with the long-run neutrality of money. ° Is there ER overshooting? 6
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Effects of Permanent Changes in Fiscal Policy ° A permanent increase in government purchases or reduction in taxes increases aggregate demand = ) DD shifts right. ° Higher demand also makes people expect the domestic currency to appreciate in the short run (b/c now the change in G is permanent). The resulting fall in E e pushes AA to the left. ° At point 2 is the new short-run equilibrium with appreciated domestic currency and un- changed Y f : ° Key: The ²rst e/ect increases aggregate demand of domestic products, while the second e/ect decreases aggregate demand of domestic products (by making them more expensive). Without this e/ect coming from changing E e ; the economy would be in point 3, with higher Y and smaller appreciation. ° The appreciation e/ect coming from E e "crowds out" aggregate demand for domestic prod- ucts. ° If the change in ²scal policy is expected to be permanent, the ²rst and second e/ects exactly o/set each other, so that output remains at its full employment (or long run) level. 7
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Effects of Permanent Changes in Fiscal Policy ° Under the assumptions we made, ²scal expansion has no net e/ect on output. 8
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Why permanent Changes in Fiscal Policy have no net effect on Y? Reasoning: 1. Fiscal expansion has no e/ect on M s ; R; Y f ; so it has no impact on the long-run P: 2. We assumed that the economy starts out in its long-run equilibrium, with R = R ± and Y = Y f : Also we argued in 1. that real money balances, M s =P are unchanged after monetary expansion in the short-run. 3. Now imagine that Y did rise above Y f : This raises money demand. Now, because M s =P did not change, R would have to rise to keep money market in equilibrium, so that now R > R ± : So, for the foreign exchange market to remain in equilibrium, people must expect the domestic currency to depreciate . 4. But there is a contradiction : We already know that ²scal expansion leaves long-run price level unchanged. The only way, therefore, the currency can be expected to depreciate is if the currency depreciates in real terms. But such depreciation would have an e/ect on Y itself. In particular, Y would have to increase even further due to higher demand. 5. This contradiction is resolved only if output does not rise at all after ²scal expansion.
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