Exchange rate changes in the AD-AS model

Overview

AD-AS diagram showing the demand-side effect of a depreciation and AD-AS diagram showing the supply-side effect of a depreciation.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   In using AD-AS to analyse an exchange rate change, what is on each axis and which component of aggregate demand is directly involved?

   Model answer

   The vertical axis measures the general price level and the horizontal axis measures real national output. The component directly affected is net exports, the value of exports minus imports, because a change in the exchange rate changes the price of domestic goods to foreign buyers and the price of foreign goods to domestic buyers. Changes in export and import volumes therefore shift the whole aggregate demand curve, and changes in the cost of imported inputs separately shift the short-run aggregate supply curve.

2. 2

   Describe the AD-AS diagram showing the demand-side effect of a depreciation.

   Model answer

   With the general price level on the vertical axis and real national output on the horizontal, a depreciation makes exports cheaper in foreign currency and imports dearer in domestic currency, so export volumes rise and domestic buyers switch away from imports towards home-produced substitutes. Net exports increase, so aggregate demand shifts right from AD1 to AD2, and along the upward-sloping short-run aggregate supply curve the new equilibrium has a higher real output Y2 and a higher general price level P2. Employment rises because the demand for labour is derived from the demand for output.

3. 3

   Describe the AD-AS diagram showing the supply-side effect of a depreciation.

   Model answer

   A weaker currency raises the domestic price of imported raw materials, components, energy and food, so firms' production costs rise across the economy. On a diagram with the general price level on the vertical axis and real national output on the horizontal, short-run aggregate supply shifts left from SRAS1 to SRAS2, and at the new intersection with an unchanged aggregate demand curve the general price level is higher and real output is lower. This is imported cost-push inflation, and it works in the opposite direction to the demand-side effect on output.

4. 4

   Combine the demand-side and supply-side effects of a depreciation on an AD-AS diagram and state what can and cannot be predicted.

   Model answer

   On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the improvement in net exports shifts aggregate demand right from AD1 to AD2, while the higher cost of imported inputs shifts short-run aggregate supply left from SRAS1 to SRAS2. Both shifts push the general price level up, so a depreciation is unambiguously inflationary. The effect on real output is the net of a rightward demand shift and a leftward supply shift, so it cannot be predicted from theory alone: output rises if the trade volume response is strong and the economy has spare capacity, and falls if the economy relies heavily on imported inputs and trade volumes respond weakly.

5. 5

   Describe the AD-AS diagram showing the effect of an appreciation on aggregate demand.

   Model answer

   A stronger currency makes exports dearer in foreign markets and imports cheaper at home, so export volumes fall and domestic buyers switch towards imported substitutes, reducing net exports. Aggregate demand therefore shifts left from AD1 to AD2 on a diagram with the general price level on the vertical axis and real national output on the horizontal. At the new equilibrium with the upward-sloping short-run aggregate supply curve, real output is lower and the general price level is lower, and unemployment rises in export industries and in sectors competing with imports.

6. 6

   Show the supply-side effect of an appreciation and explain the combined outcome.

   Model answer

   On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, an appreciation reduces the domestic price of imported raw materials, components and energy, so firms’ costs fall and short-run aggregate supply shifts right from SRAS1 to SRAS2, which on its own raises real output and lowers the general price level. Combined with the leftward shift of aggregate demand caused by weaker net exports, the effect on the price level is doubly downward, so an appreciation reliably reduces inflation. The effect on real output is ambiguous, since the demand shift reduces it while the supply shift raises it, though for most economies the demand effect dominates in the short run.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.