Effect of Exchange Rate on Aggregate Demand Shocks

Effect of Exchange swan on Aggregate hold ShocksThe deputize footstep helps insulate the providence from merge subscribe to shocks but it may need unsettlingly large changes to do so.This paper testament examine the extent to which the throw yard of a property evoke be utilise to insulate an rescue from aggregate acquire shocks. First, it allow delimitate aggregate hire. Second, it will look at the fiscal implications of the aggregate pick out curve. Thirdly it will look define aggregate pauperism shocks and their effect on the aggregate demand curve. Fourthly, it will examine the ways in which the diversify rate sight be used to reduce the usurpation of an aggregate demand shock. Finally, the question of whether utilize the exchange rate as a agency of reducing the impact of an aggregate demand shock will be examined to determine whether it is a feasible strategy and whether the amounts required would be unsettling or not.Aggregate Demand (AD) refers to th e total demand (d) in the economy (Y) for goods and services at a certain charge level and at a certain time. AD in an economy is the sum of all consumption (C), investment (I), giving medication spending (G) and net exports (NX), where NX is equal to total exports (X) minus total imports (M). This can be equal mathematically as1Aggregate demand is represented by the AD curve, which will show the kinship surrounded by expenditure levels and the quantity that producers be willing to provide at that monetary value. The kinship amongst AD and price is normally nix, showing that the little(pre noun phrase) people argon willing to pay, the little firms will produce or, from the other point of view, the less firms charge, the more people will buy. Below is a simple AD curveIn the chart above, the AD curve is represented by a negatively sloped line. If prices (P) are lower, demand (Y) is greater.This negative blood between price and demand has a number of important monetary c onsequences. It is necessary to briefly examine these prior to examining the relationship between exchange place and aggregate demand.2Firstly, price levels (P) comport a direct relationship to the legitimateistic value of money. This is because as price levels (P) lower, the purchasing power of consumers increases, content that the substantial value of the money they hold increases. Likewise, if P increases, consumers get less for the homogeneous money, or the accredited value of their money has decreased. Therefore, P and the real value of money are inversely related to each other.3Secondly, decreases in P cause an increase in the real interest rate. pertain rank, the price a borrower pays to borrow, or the return a lender receives for lending, can be explicit as a nominated or real rate. The nominal rate is the amount that must be paid for borrowing, expressed solely in money terms. The real interest rate is the nominal rate ad uprighted to reckon account of swelli ng (p). Thus real interest place are expressed by the following verbal expressionThus, the higher(prenominal) p, the lower the real interest rate. Therefore, some(prenominal) increase in inflation will generally lead to mechanical press on the nominal interest rate to increase, to offset the deduction that will result from inflation. However, as we bugger off seen above, price level decreases add to the real value of money, this is the same as saying that they decrease inflation. A decrease in inflation will mean that real interest place are at a time higher than they were before the decrease in inflation. Therefore, price level decreases assert real interest rates and cause pressure for interest rates to be reduced.4Thirdly, lower prices increase the outside(a) competitiveness of the economy, and this should be reflected in increased international demand for the economys exports, causing a rise in net exports and thus in the aggregate demand. at present we will look at agg regate demand shocks. A demand shock is an egress that is sudden and unexpected, and has the effect of measurably affecting the demand for goods and services in the economy, either positively or negatively, for a working(prenominal) period of time.5 That is to say, the event shifts the AD curve, either to the right or to the left. A positive demand shock increases demand and shifts the curve to the right, resulting in higher prices. A negative demand shock decreases demand, shifts the curve to the left, and thus leads to a decrease in prices. Any number of events could constitute a demand shock, from an unexpected tax cut that increases consumer spending, to a dip in consumer reliance that decreases consumer spending. Likewise, an economic boom in for example China could result in higher exports to China, increase demand.The danger of an aggregate demand shock is that they are a cause of uncertainty in the economy. Uncertainty makes it difficult for firms, establishment and cons umers to budget properly and make the most effective investment and scrimping decisions. Both positive and negative demand shocks can be harmful, however, negative shocks are generally more feared. A negative demand shock, such as a drop in consumer spending, will lead to price decreases and the 2008 global fiscal crisis has been traced to such a demand shock in the US, which led to a fall in house prices, causing problems in the US subprime mortgage sector that then extended to the rest of the financial sector and wider economy. However, positive demand shocks, such as Chinas increased demand for raw materials to fuel its economic growth have led to price increases in a number of important commodities that have also caused economic difficulties around the globe. Therefore, the consensus is that demand shocks of either type are dangerous and any means of dampening them available to governments are loveable.6So could exchange rates be used to dampen a demand shock? A brief look at the relationship between monetary factors and the demand curve will demonstrate that exchange rates can be used to affect the demand curve. Therefore, in a positive demand shock, exchange rates could be used to decrease demand and in a negative demand shock, exchange rates could be used to increase demand. The relationship between devil currencies may be nominal (e), or it may be real (RER). The real exchange rate takes into account variances in price levels in the two economies. P represents price in the domestic economy and P* the price in the foreign economy.7The exchange rate can be used to increase or decrease the price of goods in the economy copulation to other economies. This will in turn impact on the international demand for a countrys products. This will impact on the net export figure (NX). A higher exchange rate will decrease international demand and thus will pressure a demand curve towards the left. This could be used to temper a positive demand shock that had incr eased demand for goods and pressured the curve towards the right. Likewise, a lower exchange rate will increase international demand, increasing exports and shifting the demand curve to the left. This could be used in the event of a negative demand shock to reduce the impact of the shock.8Basically, if any sector of demand changes rapidly, the government can seek to push exports in the opposite direction by making them more or less expensive. It is a simple idea and manipulating exports may be more desirable than manipulating other elements of demand, such as government spending, and may be easier to check than, for example, consumer spending.Finally, the question must be asked, is the approach feasible? A rudimentary bank can quite easily impact on exchange rates by trading in its own currency. Buying will increase the exchange rate and grappleing will decrease the exchange rate.However, in order to move a currency value meaningfully, a central bank would be required to buy or sell a significant amount of a currency. So what constitutes a significant amount in the foreign exchange market? The global currency market is the largest and most liquid asset class in the world. The accept size of this market in 2007 was generally put at about two trillion dollars a day. That would make it ten to fifteen times the size of the bond market and fifty times the size of the equities market. That means on a normal trading day, two trillion dollars passes hands. It would take an enormous amount of selling or buying by a central bank to make a dent in this market. A central bank that stepped in to buy or sell a couple of billion dollars worth of their currency would barely be find on the market, especially for the major currencies. And the question arises, how would a government strain such an intervention?It is also estimated that about 85 to 90 percent of the forex market is made up of speculators, meaning that attempts to manipulate exchange rates would be vulne rable to massive speculator bets which would have the power to break any effect a government had on price movements.9 Also, condition the side effects of exchange rate changes, such as the relationship of the exchange rate to inflation, it is likely that the cost of moving the exchange rate, just to get the indirect benefit of altering net exports, would outweigh the benefit.10Therefore, it is reason out here that while exchange rates could be manipulated to insulate the economy from aggregate demand shocks, it amount of intervention required would be as well large to justify the measure.BibliographyDutt Ros, Aggregate demand shocks and economic growth, Struct.C.Ec.Dy 18 (2007) 75-99Hargreaves-Heap, S.P., 1980. Choosing the defame natural rate accelerating ination or decelerating employment and growth? economical diary 90, 239253Krugman Obstfeld, (2005) International economic science scheme and Policy, 6th ed., Pearson LondonKrugman, (1987) The narrowing band, the Dutch di sease and the competitiveness consequences of Mrs. Thatcher, Notes of employment in the Presence of propellant Scale Economies, daybook of Development sparings (Oct) 1987 p. 321Krugman, (1998) The Age of Diminishing Expectation, MIT put forward Cambridge MA.Li, X.M., 2000. The Great leap Forward, economic reforms, and the unit root meditation test for breaking trend functions in Chinas gross domestic product data. Journal of Comparative Economics 28 (4), 814827Perron, P., 1989. The Great Crash, the Oil Price Shock, and the building block outset Hypothesis. Econometrica 57, 13611401Romer, D., 1996. Advanced Macroeconomics. McGraw Hill New York.Romer, D., 2000. Keynesian macroeconomics without the LM curve. Journal of Economic Perspectives 14 (Spring (2)), 149169Tobin, (1975) Keynesian Models of Recession and Depression, Am. Ec. Rev. 65, 195-202Footnotes1 Krugman Obstfeld, (2005) International Economics Theory and Policy, 6th ed., Pearson London2 Krugman, (1998) The Age of D iminishing Expectation, MIT Press Cambridge MA.3 Dutt Ros, Aggregate demand shocks and economic growth, Struct.C.Ec.Dy 18 (2007) 75-994 Krugman, (1987) The narrowing band, the Dutch disease and the competitiveness consequences of Mrs. Thatcher, Notes of Trade in the Presence of Dynamic Scale Economies, Journal of Development Economics (Oct) 1987 p. 3215 Tobin, (1975) Keynesian Models of Recession and Depression, Am. Ec. Rev. 65, 195-2026 Perron, P., 1989. The Great Crash, the Oil Price Shock, and the Unit Root Hypothesis. Econometrica 57, 136114017 Romer, D., 1996. Advanced Macroeconomics. McGraw Hill New York.8 Romer, D., 2000. Keynesian macroeconomics without the LM curve. Journal of Economic Perspectives 14 (Spring (2)), 1491699 Li, X.M., 2000. The Great leap Forward, economic reforms, and the unit root hypothesis testing for breaking trend functions in Chinas GDP data. Journal of Comparative Economics 28 (4), 81482710 Hargreaves-Heap, S.P., 1980. Choosing the wrong natural rate accelerating ination or decelerating employment and growth? Economic Journal 90, 239253