Question

Suppose an economy is in equilibrium and initial equilibrium output equals its full-employment level, denoted Yf. Suddenly there is a temporary shift in consumer tastes away from domestic products. Show the effects of such a shift on output and exchange rate. (Hint: Use DD and AA curves)

Answer 1

If there is a temporary shift in consumer tastes away from domestic products, then the demand for imports and for foreign currency will increase, as a result both the output and exchange rate will decrease.