the foreign exchange market (FOREX)

Assume that Valdoria is a small open economy with a flexible exchange rate for its currency, the dorin. Valdoria is currently in long-run macroeconomic equilibrium, with unemployment at 5.0%, equal to the natural rate of unemployment, and inflation at 2.0%. Suppose that rising incomes in Valdoria's trading partners cause an increase in foreign demand for Valdorian exports.

(a) Draw a correctly labeled graph of the foreign exchange market for the dorin (Valdoria's currency), showing:

• (i) the initial demand for dorin, $D_1$, and the initial supply of dorin, $S_1$

• (ii) the initial equilibrium exchange rate, $e_1$, and quantity of dorin exchanged, $Q_1$
  (b) On your graph in part (a), show the effect of the increase in foreign demand for Valdorian exports on the market for dorin: draw the new demand curve $D_2$ and label the new equilibrium exchange rate $e_2$ and quantity $Q_2$.
  (c) Explain how the change in the equilibrium exchange rate you identified in part (b) affects the price of Valdorian goods and services in terms of foreign currency.
  (d) Identify the account of Valdoria's balance of payments in which the initial transactions from foreign consumers purchasing Valdorian exports are recorded.
  (e) Draw a correctly labeled graph of aggregate demand (AD), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS) for Valdoria, showing:

• (i) the initial long-run equilibrium at full-employment output $Y_F$ and price level $PL_1$, where $AD_1$, $SRAS_1$, and LRAS intersect

• (ii) the effect of the increase in net exports, resulting from the initial increase in foreign demand for Valdorian exports, on aggregate demand, labeling the new short-run equilibrium output $Y_2$ and price level $PL_2$
  (f)(i) Given the change in relative prices you identified in part (c), will Valdorian exports increase, decrease, or remain the same as a direct result of the appreciation of the dorin? Explain.
  (f)(ii) Given the change in relative prices you identified in part (c), will imports into Valdoria increase, decrease, or remain the same? Explain.