Economics, 3rd Edition

A Shift in Consumer Preferences with Flexible Exchange Rates

The fall in German aggregate demand leads, before prices have had time to adjust, to a fall in output from Y

1

G

 to Y

3

G

. However, because 

this is due to a fall in net foreign demand, the value of the German currency falls, making German goods cheaper abroad. This raises 

net exports and restores aggregate demand. The converse happens in France: the increase in net foreign demand raises the external 

value of the French currency, making French goods more expensive abroad and choking off aggregate demand to its former level.

Long-run

aggregate

supply

Price

level

Quantity of output

A

G

AD

2

G

AD

1

G

AS

1

G

Y

1

G

Y

3

G

Long-run

aggregate

supply

Price

level

Quantity of output

A

F

AD

2

F

AS

1

F

Y

1

F

Y

3

F

AD

1

F