Transcript Chapter 16 Output and the Exchange Rate: the Short-Run

Determinants of Aggregate
Demand in an Open Economy
 Aggregate demand: The amount of a country’s
goods and services demanded by households and
firms throughout the world.
D = C + I + G + CA
• Consumption demand C = C(Yd)
– The increase in consumption demand is less than the
increase in the disposable income because part of the
income increase is saved.
• Investment demand I
• Government demand G
• Current account CA = EX – IM = CA(EP*/P,Yd)
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Slide 16-1
Determinants of Aggregate
Demand in an Open Economy
 Real Exchange Rate
q = EP*/P
• Increase in q  real depreciation  increase in EX
– Each unit of domestic output purchases fewer units of foreign
output  foreigners get a better deal on our output 
foreigners buy more of our exports  volume of EX up
• Increase in q can raise or lower IM and has an ambiguous
effect on CA.
Volume effect: we buy fewer imports when q increases
Value effect: we pay more in real terms (in units of domestic
product) for the imports we do buy when q increases
We assume that the volume effect of a real exchange rate change
outweighs the value effect: q up  CA “improves”.
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Slide 16-2
Determinants of Aggregate
Demand in an Open Economy
Factors Determining the Current Account
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Slide 16-3
The Equation of Aggregate Demand
Aggregate Demand as a Function of Output
Aggregate
demand, D
Aggregate demand function,
D(EP*/P, Y – T, I, G)
45°
Output (real income), Y
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Slide 16-4
Output market equilibrium in the short-run: The Keynesian Cross.
Real output, Y, equals aggregate demand for domestic output:
Y = D(EP*/P, Y – T, I, G)
Aggregate
demand, D
Aggregate demand =
aggregate output, D = Y
Aggregate demand
D1
1
3
Y1
Y3
2
45°
Y2
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Output, Y
Slide 16-5
Output Market Equilibrium in the
Short Run: The DD Schedule
Output, the Exchange Rate, and Output Market Equilibrium
• With P and P* fixed, depreciation makes foreign goods
and services more expensive relative to domestic goods
and services.
– q up (real depreciation) upward shift in
aggregate demand (D) expansion of output (Y).
– q down  downward shift in D  Y down
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Slide 16-6
Output Market Equilibrium in the
Short Run: The DD Schedule
Output Effect of a Currency Depreciation with Fixed
Output Prices
Aggregate
demand, D
D=Y
Currency
depreciates
2
Aggregate demand (E2)
Aggregate demand (E1)
1
45°
Y1
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Y2
Output, Y
Slide 16-7
The DD Schedule: combinations of output and the exchange rate
where output market is in short-run equilibrium (Y = D). DD slopes
upward -- a rise in the exchange rate (depreciation) Y increases.
Aggregate demand, D
D=Y
Aggregate demand (E2)
Aggregate demand (E1)
Exchange rate, E
Y1
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Output, Y
DD
E2
E1
Y2
2
1
Y1
Y2
Output, Y
Slide 16-8
Output Market Equilibrium in the
Short Run: The DD Schedule
 Factors that Shift the DD Schedule.
•
•
•
•
•
•
•
Increases in
Government purchases  expansion  DD shifts out
Taxes  contraction  DD shifts in
Investment  expansion  DD shifts out
Domestic price levels contraction in CA DD shifts in
Foreign price levels  expansion in CA  DD shifts out
Domestic consumption  expansion  DD shifts out
Demand shift between foreign and domestic goods
 A disturbance that raises (lowers) aggregate demand for
domestic output shifts the DD schedule to the right (left).
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Slide 16-9
Output Market Equilibrium in the
Short Run: The DD Schedule
Government Demand and the Position of the DD Schedule
Aggregate demand, D
Government
spending rises
D=Y
D(E0P*/P, Y – T, I, G2)
Aggregate demand curves
D(E0P*/P, Y – T, I, G1)
Y1
Exchange rate, E
Y2
Output, Y
DD1
DD2
E0
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1
2
Y1
Y2
Output, Y
Slide 16-10
AA Schedule: combinations of exchange rate and output that
are consistent with asset market equilibrium (the domestic
money market and the foreign exchange market).
Foreign exchange market equilibrium (interest rate parity):
R = R* + (Ee – E)/E
where: Ee is the expected future exchange rate
R is the interest rate on domestic currency deposits
R* is the interest rate on foreign currency deposits
Money Market equilibrium
Ms/P = L(R, Y)
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Slide 16-11
Asset Market Equilibrium in the
Short Run: The AA Schedule
Output and the Exchange Rate in Asset Market Equilibrium:
Y up  Ld up  R up  E down (currency appreciates)
Exchange Rate, E
Foreign
exchange
market
E1
E2
0
Money
market
1'
2'
R1 R2
Domestic-currency
return on foreigncurrency deposits Domestic
interest
rate, R
L(R, Y1)
L(R, Y2)
MS
P
Output rises
1
2
Real money
supply
Real domestic money holdings
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Slide 16-12
Asset Market Equilibrium in the
Short Run: The AA Schedule
The AA Schedule: Y up  E down (currency appreciation)
Exchange
Rate, E
1
E1
2
E2
AA
Y1
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Y2
Output, Y
Slide 16-13
Asset Market Equilibrium in the
Short Run: The AA Schedule
Factors that Shift the AA Schedule
 For given Y
Domestic money supply: Ms up  R down  E up
Domestic price level: P up  Ms/P down  R up  E down
Expected future exchange rate: Ee up  E up
Foreign interest rate: R* up  E up (depreciation)
Real money demand: Ld up  R up  E down (appreciation)
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Slide 16-14
Short-Run Equilibrium for an Open Economy:
Putting the DD and AA Schedules Together
Short-Run Equilibrium: The Intersection of DD and AA
Exchange
Rate, E
DD
1
E1
Y1
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Output, Y
Slide 16-15
Short-Run Equilibrium for an Open Economy:
Putting the DD and AA Schedules Together
How the Economy Reaches Its Short-Run Equilibrium: asset markets
clear instantly  always on AA curve
$ cheap at 2  Expected $ appreciation  rush to US assets  $ appreciation NOW
Exchange
Rate, E
E2
E3
DD
2
3
1
E1
AA
Y1
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Output, Y
Slide 16-16
Temporary Changes
in Monetary and Fiscal Policy
 Two types of government policy:
• Monetary policy: works through changes in money supply.
• Fiscal policy: works through changes in government
spending (G) or taxes (T).
– Temporary policy shifts are those that the public expects to be
reversed in the near future and do not affect the long-run
expected exchange rate.
– Also, assume policy shifts do not influence the foreign interest
rate and the foreign price level.
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Slide 16-17
Temporary Change in Monetary Policy
Temporary Increase in the Money Supply: R down  E up
(depreciation) at each value of Y  AA shifts up
Exchange
Rate, E
DD
2
E2
1
E1
AA2
AA1
Y1
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Y2
Output, Y
Slide 16-18
Temporary Change in Fiscal Policy
Temporary Fiscal Expansion: G up  Y increases at each value of E 
DD shifts outward
Exchange
Rate, E
DD1
DD2
1
E1
2
E2
AA
Y1
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Y2
Output, Y
Slide 16-19
Temporary Changes in Monetary and Fiscal Policy
Maintaining Full Employment After a Temporary Fall in
World Demand for Domestic Products: Prop up demand with fiscal or
monetary stimulus (M up  AA shifts up; G up  DD shifts out)
Exchange
Rate, E
DD2
DD1
E3
3
2
E2
AA2
1
E1
AA1
Y2
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Yf
Output, Y
Slide 16-20
Temporary Changes
in Monetary and Fiscal Policy
Policies to Maintain Full Employment After Money-Demand Up
(Money “shortage”  recession). So Increase G or Ms
Exchange
Rate, E
DD1
DD2
E1
1
2
E2
AA1
3
E3
AA2
Y2
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Yf
Output, Y
Slide 16-21
Problems of Policy Formulation
• Inflation bias
– High inflation with no average gain in output that
results from governments’ policies to prevent recession
•
•
•
•
•
Identifying the sources of economic changes
Identifying the durations of economic changes
The impact of fiscal policy on the government budget
Time lags in implementing policies
Policy impacts on current account balance
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Slide 16-22
Permanent Shifts in
Monetary and Fiscal Policy
 A permanent policy shift affects not only the current
value of the government’s policy instrument but also the
long-run exchange rate.
• This affects expectations about future exchange rates.
 A Permanent Increase in the Money Supply
expected future exchange rate (Ee)rises proportionally 
upward shift in AA schedule is greater than that caused by
an equal, but transitory, increase
 need expected appreciation in the future to offset lower
interest rate, R
OVERSHOOTING
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Slide 16-23
Permanent Shifts in
Monetary and Fiscal Policy
Short-Run Effects of a Permanent Increase in the Money
Supply (E3 is newly expected long-run exchange rate)
Exchange
Rate, E
DD1
2
E2
3
1
E1
AA2
AA1
Yf
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Y2
Output, Y
Slide 16-24
Permanent Shifts in
Monetary and Fiscal Policy
Long-Run Adjustment to a Permanent Increase in Money Supply
(As P rises, CA worsens (DD in) and R rises (AA down)
Exchange
Rate, E
DD2
DD1
2
E2
E3
E1
3
AA2
1
AA3
AA1
Yf
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Y2
Output, Y
Slide 16-25
Permanent Fiscal Expansion
Expected Appreciation Shifts AA Down Immediately
No Change in Output, Even in Short-Run
Complete Crowding Out
Exchange
Rate, E
DD1
DD2
E1
1
3
AA1
2
E2
AA2
Yf
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Output, Y
Slide 16-26
Macroeconomic Policies
and the Current Account
 XX schedule shows combinations of the exchange rate and
output at which the CA balance stays at some desired
level.
• XX slopes upward: Y up  Im up  CA worsens unless
currency depreciates.
– E must increase to keep CA where it was when Y up.
• XX is flatter than DD:
– When currency depreciates (E up), CA improves along DD –
that’s why Y increases when currency depreciates.
– To keep CA from changing, E need only increase enough to
offset increased imports attributable to output expansion.
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Slide 16-27
Monetary Expansion  AA shifts up  Depreciation 
CA “improves” (Point 2)
Fiscal Expansion  DD shifts out  Appreciation  CA
“worsens” (Point 3 for temporary fiscal expansion; Point 4 for
permanent fiscal expansion).
Exchange
Rate, E
DD
XX
2
1
E1
3
4
Yf
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Output, Y
Slide 16-28
Gradual Trade Flow Adjustment
and Current Account Dynamics
 The J-Curve:
if imports and exports adjust gradually
to real exchange rate changes, the CA may follow a Jcurve pattern after a real currency depreciation, first
worsening and then improving.
– Currency depreciation may have a contractionary initial
effect on output
– exchange rate overshooting will be amplified.
• The J-Curve describes the time lag with which a real
currency depreciation improves the CA.
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Slide 16-29
Gradual Trade Flow Adjustment
and Current Account Dynamics
The J-Curve
Current account (in
domestic output units)
Long-run
effect of real
depreciation
on the current
account
1
3
2
Time
Real depreciation takes
place and J-curve begins
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End of J-curve
Slide 16-30
Gradual Trade Flow Adjustment
and Current Account Dynamics
 Exchange Rate Pass-Through and Inflation
• The CA in the DD-AA model has assumed that
nominal exchange rate changes cause proportional
changes in the real exchange rates in the short run.
• Degree of Pass-through
– It is the percentage by which import prices rise when the
home currency depreciates by 1%.
– In the DD-AA model, the degree of pass-through is 1.
– Exchange rate pass-through can be incomplete because
of international market segmentation.
– Currency movements have less-than-proportional effects on the
relative prices determining trade volumes.
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Slide 16-31
Summary
 The aggregate demand for an open economy’s output


consists of four components: consumption demand,
investment demand, government demand, and the
current account.
Output is determined in the short run by the equality
of aggregate demand and aggregate supply.
The economy’s short-run equilibrium occurs at the
exchange rate and output level.
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Slide 16-32
Summary
 A temporary increase in the money supply causes a


depreciation of the currency and a rise in output.
Permanent shifts in the money supply cause sharper
exchange rate movements and therefore have stronger
short-run effects on output than transitory shifts.
If exports and imports adjust gradually to real
exchange rate changes, the current account may
follow a J-curve pattern after a real currency
depreciation, first worsening and then improving.
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Slide 16-33
Appendix I: The IS-LM Model
and the DD-AA Model
Figure 16AI-1: Short-Run Equilibrium in the IS-LM Model
Interest
rate, R
LM
1
R1
Y1
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Output, Y
Slide 16-34
Appendix I: The IS-LM Model
and the DD-AA Model
Figure 16AI-2: Effects of Permanent and Temporary Increases in the
Money Supply in the IS-LM Model
1
LM
Expected
domestic-currency
return on
foreign-currency
deposits
Interest rate, R
1´
2´
E2
E3
Exchange rate, E
1
R1
R2
2
3
R3
3´
LM2
E1
Y1
Y3
Y2
Output, Y
( increasing)
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Slide 16-35
Appendix I: The IS-LM Model and
the DD-AA Model
Figure 16AI-3: Effects of Permanent and Temporary Fiscal
Expansions in the IS-LM Model
Expected
domestic-currency
return on
foreign-currency
deposits
1´
E1
Exchange rate, E
Interest rate, R
R2
2´
3´
E2
LM
R1
E3
2
1
Yf
Y2
Output, Y
( increasing)
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Slide 16-36
Appendix II: Intertemporal Trade
and Consumption Demand
Figure 16AII-1: Change in Output and Saving
Future
consumption
D2F
D1
F
=
Q1
Intertemporal
budget constraints
2
1
F
2´
Indifference
curves
D1P = Q1P
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D2P Q2P Present
consumption
Slide 16-37
Appendix III: The Marshall-Lerner Condition
and Empirical Estimates of Trade Elasticities
Table 16AIII-1: Estimated Price Elasticities for International Trade
in Manufactured Goods
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Slide 16-38