Question

In the short run, any fall in EP /P, regardless of its causes, will cause A) an upward shift in the aggregate demand function and an expansion of output. B) an upward shift in the aggregate demand function and a reduction in output. C) a downward shift in the aggregate demand function and an expansion of output. D) an downward shift in the aggregate demand function and a reduction in output. E) an upward shift in the aggregate demand function but leaves output intact.

Answer 1

Answer: D) an downward shift in the aggregate demand function and a reduction in output.

Explanation:

EP/P is the real exchange rate. Any fall in this rate will mean that the demand will decrease because the currency becomes weaker and is therefore unable to buy as much as it used to.

For that same reason, output will reduce because producers will find that the inputs to production will become more expensive which would mean that they have to produce less in order to maintain profitability.