International Finance Theory and Policy
by Steven M. Suranovic

Finance 50-11

Effect of an Increase in the US Dollar Value on Real GNP

Suppose the economy is initially in equilibrium in the G&S market with the exchange rate at level E1$/£ and real GNP at Y1 as shown in the adjoining diagram. The initial AD function is written as AD(...,E1$/£, ...) to signify the level of the exchange rate and to denote that other variables affect AD and are at some initial and unspecified values.

Next suppose the US dollar value rises, corresponding to a decrease in the exchange rate from E1$/£ to E2$/£, ceteris paribus. As explained in section 50-5, the increase in the spot dollar value also increases the real dollar value causing foreign G&S to become relatively cheaper and US G&S to become more expensive. This change reduces demand for US exports and increases import demand resulting in a reduction in aggregate demand. The ceteris paribus assumption means that all other exogenous variables are assumed to remain fixed.

Since the higher dollar value lowers aggregate demand, the AD function shifts down from AD(..,E1$/£, ..) to AD(..,E2$/£, ..) (step 1) Equilibrium GNP in turn falls to Y2. (step 2). Thus the increase in the US dollar value causes a decrease in real GNP.

The adjustment process follows the GNP too high story. When the dollar value rises, but before GNP falls to adjust, Y1 > AD. The excess supply of G&S raises inventories causing merchants to decrease order size. This leads firms to decrease output, lowering GNP.

International Finance Theory and Policy - Chapter 50-11: Last Updated on 5/17/06

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