Micro economics - Stronger domestic currencies and AD shifts

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mineral

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Im confused with the answer to this question:
11. A stronger domestic currency relative to foreign currencies is most likely to result in a:
A. Shift in the aggregate supply curve to lower supply
B. shift in the aggregate demand curve towards lower demand
C. Movement along the aggregate demand curve towards higher prices
The answer says B because a stronger currency will cause exports to decrease and imports to increase, causing the AD curve to shift to the left (lower demand).
I understand the first part of the answer, but not the 2nd part of the answer. Why does the curve shift to the left?
Thanks in advance.
 
mineral wrote:
Im confused with the answer to this question:
11. A stronger domestic currency relative to foreign currencies is most likely to result in a:
A. Shift in the aggregate supply curve to lower supply
B. shift in the aggregate demand curve towards lower demand
C. Movement along the aggregate demand curve towards higher prices
The answer says B because a stronger currency will cause exports to decrease and imports to increase, causing the AD curve to shift to the left (lower demand).
I understand the first part of the answer, but not the 2nd part of the answer. Why does the curve shift to the left?
Thanks in advance.
Click to expand...
This is a very simplistic and non-technical explanation:
If a country is exporting less goods and services (because foreigners are DEMANDING less from this country at each price level), and the country is importing more foreign goods (the domestic people are DEMANDING less domestic goods in lieu of foreign goods and services [again, at each price level]), then the aggregate (total) demand for this country’s goods and services has declined (leftward shift).
Also, my emphasis on the word “DEMANDING” is hopefully a silly way to make the explanation stick.
Hope this helps!
 
Let’s use an example to understand the variables movements.
For example, right now the USD / EUR = 0.91 This means that we need 0.91 cents of euro to buy 1.00 dollar. In this case the domestic currency is EUR and USD is the foreign ok? (this is a global convention I guess)
What happens if the USD / EUR goes to 0.85?. This means that the Exchange Rate has fallen, the domestic currency EUR is stronger (appreciated) and the foreign currency is weaker (depreciated). Why EUR is stronger now? Because it needs less eur cents to buy the same 1 dollar.
What is the effect on the AD curve? Since we can buy the same quantity of dollars with less euros, or buy more dollars with the same initial quantity of euros we have more importation purchase power (the foreign goods are cheaper for us now), so we import more goods and services. Since importation reduces AD (leaving all other variables constant), a higher importation level will shift the AD curve to the left.
Regards
 
I forgot to say that the opposite effect is on the exportations. Since the ER has fallen, the companies that export goods and services are receiving less income from their sales (because they receive foreign currency) and their costs are in domestic currency, so they are getting lower profit spreads. Some companies will retreat from the exportaion market momentarily and others will look for national customers until the conditions are suitable again for more exportations.
Summing up, less exports and higher imports lead to lower Aggregate demand, the AD curve shifts to the left.
Regards
 
Harrogath wrote:
Let’s use an example to understand the variables movements.
For example, right now the USD / EUR = 0.91 This means that we need 0.91 cents of euro to buy 1.00 dollar. In this case the domestic currency is EUR and USD is the foreign ok? (this is a global convention I guess)
What happens if the USD / EUR goes to 0.85?. This means that the Exchange Rate has fallen, the domestic currency EUR is stronger (appreciated) and the foreign currency is weaker (depreciated). Why EUR is stronger now? Because it needs less eur cents to buy the same 1 dollar.
What is the effect on the AD curve? Since we can buy the same quantity of dollars with less euros, or buy more dollars with the same initial quantity of euros we have more importation purchase power (the foreign goods are cheaper for us now), so we import more goods and services. Since importation reduces AD (leaving all other variables constant), a higher importation level will shift the AD curve to the left.
Regards
Click to expand...
Thanks, I understand your post. However I can’t instantly understand this statement. “Since importation reduces AD (leaving all other variables constant), a higher importation level will shift the AD curve to the left”
Why does importation reduce AD? Is that because AD is just for internal aggregate demand (i.e. within the domestic market)?
 
GDP level is equal to the aggregate demand.
GDP = AD = C + I + G + ( X - M )
I think you already know this equation. C is private consumption, I is private investment, G is public consumption and public investment, and finally X is exports and M is imports.
As you can see, M reduces AD because when we import goods and services the resources spent in them are trasladated to a foreign country.
Any question relating to aggregate demand refers to the GDP itself.
Regards
 
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