Assume the model of simultaneous short-run equilibrium in output market and asset market under the floating exchange rate regime. How would you best describe the relationship between domestic currency exchange rate and output? Select one – the most appropriate answer.

Question

BlackTom AI · Accepted Answer

The question asks about the relationship between the domestic currency exchange rate and output under a model of simultaneous short-run equilibrium in the output market and the asset market with a floating exchange rate regime.

Option given: "When domestic currency depreciates it makes domestic goods and services less expensive compared to foreign goods and services bringing about the aggregate demand increase and consequently increase in output."

First, consider what a depreciation of the domestic currency does in a small open economy with floating rates. A depreciation lowers the price of domestic goods in foreign currency terms relative to foreign goods, which tends to boost exports and reduce imports, improving net exports (NX). Net exports are a component of aggregate demand (AD = C + I + G + NX). Thus, a depreciation tends to shift the AD curve to the right, increasing overall output in the short run, assuming prices are sticky and monetary policy supports the adjustment. This aligns with the standard Mundell-Fleming framework for a small open economy in the short run, where depreciation stimulates AD and output.

Why this option is plausible: It correctly links currency depreciation to a more competitive export sector and to higher AD, which, in the short run, tends to raise output. The mechanism described—domestic goods becoming relatively cheaper for foreigners and the consequent increase in AD—captures the core cause-and-effect relationship expected under floating rates with simultaneous goods and asset market equilibrium.

Why other options (if they existed) might be incorrect conceptually: In many models, depreciation does not make domestic goods more expensive; it makes them cheaper for foreigners. Also, the impact is not limited to one-sided effects on prices or demand; exchange-rate movements influence NX, which in turn affects AD and output. If an option claimed depreciation has no effect on output, or that it only affects inflation with no real output impact, it would contradict the typical short-run Mundell-Fleming intuition. If an option suggested that depreciation only affects the asset market without real-sector consequences, it would neglect the cross-channel effects through NX and AD. If an option claimed depreciation worsens the trade balance in all scenarios, it would ignore the possibility of a rebound in exports and reduced imports that can improve NX in the short run.

In summary, the stated option captures the essential transmission mechanism: depreciation lowers relative prices of domestic goods abroad, boosts net exports, increases aggregate demand, and raises short-run output. The line of reasoning follows the conventional short-run open-economy macro framework under a floating exchange rate regime, where exchange-rate movements have real effects through the trade balance and demand components.

Assume the model of simultaneous short-run equilibrium in output market and asset market under the floating exchange rate regime. How would you best describe the relationship between domestic currency exchange rate and output? Select one – the most appropriate answer.Single choice

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