Question

Suppose the government of a country wants to maintain full employment, there has been a rise in the demand for its products by foreigners. using the dd-aa framework graphically show and discuss how the country can use monetary and fiscal policy to maintain full employment. contrast and discuss the effect of the two policies on the nominal exchange rate.

Answer 1

Most of the government used the full employment policies to maintain the economic growth and development. This can be attained through high demand of foreign customers. The export become cheap and import become expensive. So most of the domestic firms increase their output level and increase the export. This can be represented through AA-DD model. This model explains the simultaneous equilibrium in goods market, money market and foreign market. Both fiscal and monetary policy shows the economic development and the growth rate. If the government increased the level of expenditure, then the aggregate demand will increase and this will shift the AA curve to right. AA cure shows the simultaneous equilibrium in goods and money market. The rise in government expenditure will raise the output level and reduce the price level. Here the exchange rate increased. But this rise in exchange rate will reduce the economic growth and make the import cheaper. On the other hand, the expansionary monetary policy will increase the money supply and reduce the interest rate. This will expand the investment level and increase the economic growth rate. The simultaneous implementation of fiscal policy and monetary policy will shift the AA curve to right. A A Exchange rate E1 EO A' D A YO Y1 Output This shift in AA curve makes a negative impact in the economy through rising exchange rate. This appreciation will retard the economic development and growth. The rise in exchange rate reduces the price level. If there is fiscal expansion the level of output and domestic prices will increase at nominal exchange rate. Here the price of imports fall down and money market come under equilibrium. The nominal exchange reduces the import prices. Through fiscal and monetary expansion the markets come under equilibrium with nominal exchange rate.