Using the AD-AS model, explain the possible effects of a sustained appreciation of the local currency on the government's macroeconomic objective.

Essay by eunice88College, Undergraduate September 2006

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Assume that initially the economy is at the equilibrium level of output where aggregate demand equal to aggregate supply and this is shown diagrammatically below.

Aggregate demand is the quantity of total output demanded at a given price level and comprises total of all the consumption and investment goods and services as well as the required goods and services of the government and net exports. A sustained appreciation of the local currency would bring about negative effects to the economy in the short and long term. In the short term, the price of local goods and services would be relatively expensive to the goods and services of other countries which would consequently lead to a fall in demand of Australian goods and services. Therefore, the exports of Australian goods and services would fall accordingly as this phenomenon implies the reduction of Australian competitiveness. Simultaneously, the imports of overseas goods and services would rise to maintain the constant supply of the goods and services.

Hence, this could lead to a possible external imbalance with a falling Australian dollar value and worsened Current Account Deficit (CAD). As for the firms in Australia, they will start to cut down their production of the goods and services to remove the surplus of their goods and services because in such condition, producers find it less profitable to produce. In addition, there would be a fall in foreign investment inflow as firms are motivated by profit motive and private initiative. Thus, the level of investments of the firms in Australia would decrease. When the level of investments decrease, the level of employment would fall and this would bring to a decrease in the level of disposable income. A fall in the level of disposable income would then reduce the total consumption of household due...