8 Consumption and Import Shocks (10 Points)

Suppose prior to the coronavirus pandemic, the United States (U.S.) was in

a long-run equilibrium initially with a floating exchange rate regime. The

coronvirus pandemic caused many local businesses, shops, and restaurants

to close, decreasing consumption demand for domestic goods and services

temporarily.

a. (3 Points) Use the AA-DD-XX diagram to determine what happens

to output, the spot exchange rate, and the current account in the

U.S. as a result of the decrease in consumption, all else equal. Is the

resulting equilibrium above or below the current account target?

b. (1 Points) What type of monetary policy can the Federal Reserve

(i.e., U.S. central bank) engage to restore equilibrium output in the

short run? Explain using the AA-DD-XX diagram.

c. (1 Points) What type of monetary policy can the Federal Reserve

engage to meet the initial current account level in the short run?

Explain using the AA-DD-XX diagram.

d. (5 Points) Returning to part a., assume that the overall decrease in

consumption demand is the same, but now also assume that import

demand decreases, but not as much as consumption demand. Use

the AA-DD-XX diagram to determine how your answer would differ

under this situation compared to part a. Is the resulting equilibrium

above or below the current account target?