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economy
or
not)
who
bought
these
goods,
then
we
can
write
that
Revenue
=
AE
too.
So
AE
=
Cd
+
I
+
G
+
X
where
C
is
TOTAL
consumption
expenditure
by
local
households
on
locally
produced
goods.
If
you
are
still
not
convinced
that
M
doesnt
exist
in
AE
or
AD,
then
check
this
out:
We
then
have
to
subtract
imports
of
goods
and
services
(M)
from
the
total
in
order
to
leave
just
the
expenditure
on
domestic
product.
In
other
words,
we
subtract
the
part
of
consumers
expenditure,
government
expenditure
and
investment
that
goes
on
imports.
We
also
subtract
the
imported
component
(e.g.
raw
materials)
from
exports.
It
clearly
implies
that
1. C
=
Cd
+
Cm
2. I
=
Id
+
Im
3. G
=
Gd
+
Gm
4. X
=
Xd
+
Xm
Now
most
of
your
schools
(as
well
as
my
notes)
teach
you
a
simplified
version
where
we
assume
(for
simplicity
only)
that
I,
G
and
X
components
are
all
domestic
only,
so
that
implies
that
C
=
Cd
+
M.
So
we
can
now
rewrite
the
AE
or
AD
as
AE
=
Cd
+
I
+
G
+
X
+
M
M
Rearranging,
we
have
AE
=
Cd
+
M
+
I
+
G
+
X
M
Or
simply
AE
=
C
+
I
+
G
+
X
-
M
So
actually,
M
does
not
appear
in
AE
or
AD
at
all.
THUS,
when
exchange
rate
changes
the
only
direct
effect
on
AE
or
AD
is
through
X.
When
exchange
rate
say
falls
(i.e.
depreciates)
the
price
of
local
exports
DID
NOT
BECOME
CHEAPER
OR
MORE
EXPENSIVE
IN
LOCAL
CURRENCY
since
we
assume
ceteris
paribus.
It
only
becomes
cheaper
in
foreign
currency
terms.
Thus
foreigners
buy
more
(Law
of
Demand).
Whether
they
buy
a
lot
more
or
a
little
more
depends
on
the
value
of
PEDx.
But
regardless
of
that
values
they
WILL
BUY
MORE.
So
X
must
increase.
Many
of
you
are
taught
(in
your
school
notes)
that
the
definition
of
YED
is
the
degree
of
responsiveness
of
DEMAND
for
a
good
to
given
change
in
the
income
of
consumers,
ceteris
paribus.
This
is
CORRECT.
But
sometimes,
in
some
textbooks
as
well
as
in
my
notes,
you
are
taught
that
the
definition
is
the
degree
of
responsiveness
of
QUANTITY
DEMANDED
of
a
good
to
given
change
in
the
income
of
consumers,
ceteris
paribus.
This
is
ALSO
CORRECT.
BUT
some
of
your
teachers
insists
that
the
second
one
is
wrong.
Actually
different
text
book
use
different
definitions
for
this
concept
because
both
are
actually
correct.
When
income
changes,
it
is
DEMAND
that
changes,
so
the
first
definition
is
correct.
The
reason
why
the
second
one
is
also
correct
is
that
any
change
in
demand
is
also
equal
to
a
change
in
the
QUANTITY
DEMANDED
AT
ALL
PRICE
LEVELS.
Also,
the
formula
given
by
ANY
textbook
regarding
this
concept
is
always
percentage
change
in
quantity
demanded
divided
by
percentage
change
in
income.
Thus
both
are
correct.
However,
if
your
teacher
for
whatever
reason
insists
that
the
second
one
is
wrong,
I
suggest
that
you
write
the
first
definition
for
your
examinations
BUT
do
not
as
a
result
begin
to
think
that
only
one
of
them
is
correct.
The
same
applies
to
the
XED
concept.
foreign
inputs
would
result
in
a
less
than
10%
decrease
in
unit
COP.
Thus
for
foreigners,
our
exports
would
still
end
up
being
slightly
more
expensive
and
X
would
still
fall.
This
means
that
the
left
shift
of
the
AD
dominates
the
right
shift
of
the
SRAS
so
that
real
Y
ultimately
falls
when
the
currency
appreciates,
ceteris
paribus.
------------------
Now
some
of
you
sharper
people
will
say
that
hey
didn't
Cd
also
fall?
Youd
be
exactly
right
to
remember
that.
But
recall
also
that
Cd
fell
because
the
appreciation
made
imports
cheaper
(i.e.
Pm
fell
by
10%,
and
demand
for
locally
produced
substitutes
of
those
imports
would
fall,
the
extent
to
which
of
course
depends
on
the
XED
between
local
and
foreign
goods).
The
appreciation
also
made
imported
inputs
cheaper
and
thus
the
unit
COP
for
these
locally
produced
goods
cannot
have
stay
constant.
In
fact
they
must
have
fallen
too.
But
as
long
as
the
import
content
of
these
goods
is
100%,
i.e.
they
are
produced
entirely
using
imported
inputs,
then
unit
COP
must
have
fallen
by
exactly
10%
thus
offsetting
any
change
in
relative
prices
between
foreign
imports
and
their
local
substitutes.
Thus
any
change
in
Cd
initially
would
be
cancelled
out.
But
since
import
content
cannot
be
100%,
at
least
not
for
all
these
goods,
imports
prices
would
still
have
to
fall
more
than
the
prices
of
their
locally
produced
substitutes
and
so
Cd
must
still
fall.
As
such
the
conclusion
doesnt
change:
Ceteris
paribus,
an
appreciation
of
the
domestic
currency
shifts
AD
to
the
left
and
SRAS
to
the
right
and
the
resultant
effect
on
real
Y
is
negative.
There
is
no
elasticity
assumption
in
the
whole
analysis.
The
only
assumption
that
is
needed,
and
it
is
one
that
does
not
have
to
be
made
explicit
since
it
is
obvious,
is
that
the
import
content
of
a
countrys
goods
cannot
be
on
average
100%.
The
short
but
not
precisely
correct
answer
is
NO.
The
more
precisely
correct
answer
is
that
it
depending
on
whether
the
government
had
set
taxes
to
high.
In
early
chapters,
when
you
are
taught
about
indirect
taxes
and
subsidies,
there
is
always
a
deadweight
loss.
This
was
when
you
were
not
taught
market
failure
yet.
So
the
assumption,
which
is
sometimes
not
made
explicit
in
your
schools
notes,
is
that
the
free
market
equilibrium
output
(i.e.
the
quantity
transacted
at
equilibiurm)
originally
was
a
socially
optimal
outcome.
The
imposition
of
an
indirect
tax
or
subsidy
would
shift
the
supply
curve
vertically
up
or
down
(depending
on
whether
it
was
a
tax
or
a
subsidy)
and
thus
cause
the
market
to
adjust
to
a
new
equilibrium
output.
This
new
output
is
caused
not
by
a
change
in
either
consumers
tastes
and
preferences
or
income
or
by
changes
in
costs
of
production,
and
as
such
is
a
DEVATION
FROM
THE
SOCIAL
OPTIMUM.
Thats
why
there
is
a
deadweight
loss.
So
the
point
is
that
a
deadweight
loss
only
occurs
when
the
market
outcome
(whether
by
free
market
or
as
a
result
of
government
intervention)
is
different
from
the
social
optimum.So
in
the
case
of
a
negative
externality,
the
free
market
outcome
is
already
higher
than
the
social
optimum,
hence
there
is
over-
consumption
(or
over-production
depending
on
whether
it
is
a
consumption
externality
or
a
production
externality).
The
imposition
of
an
indirect
tax
is
aimed
to
bringing
the
market
outcome
towards
the
social
optimum,
thereby
reducing
the
deadweight
loss.
If
successfully
applied,
the
indirect
tax
would
bring
the
market
outcome
to
where
the
social
optimum
is
thereby
completely
eliminating
the
deadweight
loss
due
to
the
externality.
And
since
the
market
outcome
now
is
at
the
social
optimum
(albeit
due
to
government
intervention)
there
cannot
be
anymore
deadweight
loss.
Thus,
if
imposed
correctly,
the
indirect
tax
that
is
used
to
correct
the
market
failure
caused
by
a
negative
externality
does
not
on
its
own
cause
another
deadweight
loss.
If
however,
it
was
set
too
low
and
the
resultant
market
outcome
is
still
above
the
social
optimum,
then
a
deadweight
loss
still
exist,
but
then
it
would
still
be
the
result
of
the
negative
externality
and
not
caused
by
the
indirect
tax.
But
if
the
government
had
set
a
atx
too
high
and
caused
the
market
outcome
to
be
now
lower
than
the
social
optimum,
a
new
deadweight
loss
emerges.
This
time
it
is
due
to
the
under-consumption
due
to
over-taxing
the
good.
Then
the
new
deadweight
loss
is
caused
by
the
tax.