Transcript Linking money supply, interest rates, and exchange rates

A Short-Run Model
of an Open Economy
BA 282
Macroeconomics
Class Notes - Part 4
A Short-Run Model of an Open Economy
1
Aggregate Demand

Aggregate demand (D) is the amount of a country’s
goods and services demanded by households and
firms throughout the world




Recall GDP = C + I + G + EX - IM = D
Each of these components has various sources that
determine demand for that factor
We will concentrate here on consumption and CA
Specifically, let’s assume
C = C(YD)
and
CA = CA(E, YD)
A Short-Run Model of an Open Economy
2
Aggregate Demand and CA

To see how a change in E effects CA we look at EX
and IM Separately. Assume an increase in E


This results in an increase in EX since domestic goods
look cheaper to foreigners
This can result in an increase or decrease in IM. Why?
(for now assume an increase in E results in a decrease of IM)

An increase in YD will decrease CA. Why?
A Short-Run Model of an Open Economy
3
Aggregate Demand

We can now write a more general function for D
D = C(Y-T) + I + G + CA(E , Y-T)
where
Consumption demand (C) is a function of YD
YD = Y - T (T = aggregate taxes)
or more generally
D = D(E , Y-T, I, G)
A Short-Run Model of an Open Economy
4
Aggregate demand

Let’s review
D = D(E , Y-T, I, G)

Increasing the real exchange rate increases D through the
current account
Increasing income will






increase D through increases in consumption demand
decrease D through increasing import demand
The consumption demand effect will be greater then the import
demand effect so an increase in income will increase aggregate
demand
Increasing investment demand I increases D
Increasing government demand G increases D
A Short-Run Model of an Open Economy
5
Aggregate Demand and Output
Aggregate
Demand (D)
Aggregate Demand
D(E ,Y-T, I, G)
45o
Real
Income (Y)
A Short-Run Model of an Open Economy
6
Equilibrium in the Output Market

Equilibrium in the domestic output market will occur
when aggregate demand equals output (real
income)

In the short-run we consider prices fixed

In the long-run prices will adjust
A Short-Run Model of an Open Economy
7
Equilibrium in the Output Market
Aggregate
Demand (D)
Aggregate Demand (D) =
Aggregate Output (Y)
3
D3
1
D1
D2
Aggregate Demand
D(E ,Y-T, I, G)
2
45o
Y2
A Short-Run Model of an Open Economy
Y1
Y3
Output (Y)
8
The DD Schedule

Now we need to derive the relationship between
the exchange rate and output (the DD schedule)
when the output market is in equilibrium

To do this consider an increase in the nominal
exchange rate from E1 to E2

This will increase aggregate demand. Why?
A Short-Run Model of an Open Economy
9
Equilibrium Output after Currency Depreciation
Aggregate
Demand (D)
Aggregate Demand
D(E2 ,Y-T, I, G)
2
D2
Aggregate Demand
D(E1 ,Y-T, I, G)
1
D1
Currency
Depreciation
45o
Y1
A Short-Run Model of an Open Economy
Y2
Output (Y)
10
Deriving the DD Schedule

By noting the short-run equilibrium level in the
output market for all levels of the nominal exchange
rate we derive the DD schedule

Intuitively, the DD schedule allows us to see how
short-run fluctuations in the nominal exchange rate
impact aggregate domestic demand
A Short-Run Model of an Open Economy
11
Deriving the DD Schedule
Nominal Exchange
Rate (E)
D
DD
D2
2
D(E2)
D1
1
D(E1)
2
E2
E1
1
Output
45o
Y1
A Short-Run Model of an Open Economy
Y2
Y1
12
Y2
What Factors Shift the DD Curve?

Recall where the DD curve comes from

D(E ,Y-T, I, G)
So all of the following can shift the DD curve





Disposable income
Investment
Government spending (and taxes)
The consumption function
A demand shift between foreign and domestic
consumption
A Short-Run Model of an Open Economy
13
Example: Increase in Government Spending
Nominal Exchange
Rate (E)
E0
1
Y1
A Short-Run Model of an Open Economy
DD1
DD2
2
Y2
Output
14
The AA Schedule

The AA schedule relates exchange rates and output levels
that keep the money and foreign exchange (asset) markets
in equilibrium

We start with the interest parity condition (with RFC and Ee
held constant),
RLC = RFC + (Ee-E)/E
and the equilibrium money market equation
MS/PLC = L(RLC,Y)

Now recall money and exchange rate market equilibrium
from chapter 14 and an increase in output (Y)
A Short-Run Model of an Open Economy
15
The AA Schedule
A Short-Run Model of an Open Economy
16
The AA Schedule
So in the short run, an increase in output decreases the exchange rate
Nominal Exchange
Rate (E)
E1
1
2
E2
AA
Y1
A Short-Run Model of an Open Economy
Y2
Output
17
The AA Schedule



The AA schedule describes how exchange rates fall as
output increases
Changes in output will result in a movement along this curve
Anything that changes the stacked graphs – the foreign
exchange market and money market – except output will
shift the curve
 A change in MS for a fixed level of Y
 A change in Ee
 A change in the foreign interest rate RFC
 A change in the real money demand function L(RLC, Y)
A Short-Run Model of an Open Economy
18
Short-Run Equilibrium

We now have separate models for exchange-rate
equilibrium in the
 Output market (the DD schedule)
 Asset market (the AA schedule)

We can combine these to get a short-run equilibrium for the
whole economy
 This will be the intersection of the AA and DD schedules

To see why this is the equilibrium consider an exchange rate
above the AA schedule and on the left of the DD schedule
A Short-Run Model of an Open Economy
19
Short-Run equilibrium
Nominal Exchange
Rate (E)
DD
E2
E3
2
3
E1
1
AA
Y1
A Short-Run Model of an Open Economy
Output
20
Applications of DD-AA Model

Now that we have a general model of short-run
equilibrium we can use it to explore the impact of
various economic changes such as

Changes in fiscal and monetary policy

Changes in world demand for domestic products

Changes in money-demand
A Short-Run Model of an Open Economy
21
Monetary Policy

How does a temporary increase in the domestic money
supply affect the equilibrium of an open economy?
E
DD
2
E2
E1
1
AA2
AA1
Y1
A Short-Run Model of an Open Economy
Y2
Output
22
Fiscal Policy

How does a temporary fiscal expansion (higher G and/or
lower T) affect the equilibrium of an open economy?
E
E1
DD2
DD1
1
2
E2
AA
Y1
A Short-Run Model of an Open Economy
Y2
Output
23
Fall in World Demand for Domestic Products
How can monetary policy be used to restore the economy to its fullemployment output level after a decline in the world demand for domestic
products?
E
DD1
DD2
Monetary
Expansion
E3
E2
Drop in World
Demand
3
2
AA2
1
E1
AA1
Y2
A Short-Run Model of an Open Economy
Yf
Output
24