Question

Panem is a small open economy. Its residents has become more optimistic about their future. What will happen to Panem’s trade balance and real exchange rate? Explain using your own words and a figure.

Answer 1

Aggregate demand = Consumption + Investment + Government spending + Exports - Imports

Optimistic people will raise investment level by producers and consumption by consumers. Both of these factors combined will increase aggregate demand which raise price level in the economy.

Pring AS po AD لا لا quentity

Rise in domestic price will reduce exports as foreign consumers will find domestic goods more expensive. Reduced exports will reduce net exports. Rise in domestic price means there is rise in real exchange rate.