Final answer:
A depreciation of the dollar stimulates aggregate demand by making U.S. exports cheaper and imports more expensive, which can lead to an increase in demand for domestic goods and potential inflation or recession if the Federal Reserve tightens monetary policy.
Step-by-step explanation:
How does a depreciation of the dollar affect aggregate demand? A lower U.S. dollar would stimulate aggregate demand by making U.S. exports cheaper and imports more expensive, which in turn increases demand for domestically produced goods and services. This depreciation would cause a relative price increase of U.S. goods aboard and a decrease in foreign demand for more expensive imported goods. Additionally, higher prices for imported inputs could shift the short-term aggregate supply curve to the left. This could lead to inflation, and if the Federal Reserve tightens monetary policy in response, it could potentially bring about a recession.
Aggregate demand is influenced by the relative prices of goods in domestic and international markets, which are outlined in various tables summarizing determinants of aggregate demand, such as Table 12.1. Should U.S. goods become relatively cheaper due to a weaker dollar, U.S. exports are expected to increase. Conversely, if the price of inputs to production in the United States rises due to a change in the exchange rate, then U.S. exports might decline.