Transcript ch16x
Price Levels and the Exchange Rate in the Long Run Chapter 16 International Economics Udayan Roy Long Run and Short Run • Long run theories are useful when all prices of inputs and outputs have enough time to adjust fully to changes in supply and demand. • In the short run, some prices of inputs and outputs may not have time to adjust, due to labor contracts, costs of adjustment, or imperfect information about market demand. • This chapter discusses a theory of the long run behavior of a “small” economy with flexible exchange rates under perfect capital mobility 16-2 Long Run and Short Run Variable Long Run Short Run P, the overall price level Endogenous Exogenous Y, inflation-adjusted GNP Exogenous Endogenous Ee, expected future value of the exchange rate Endogenous Exogenous Every theory consist of exogenous variables and endogenous variables. Endogenous variables are those variables whose up and down movements the theory is trying to explain. Exogenous variables are those variables that the theory finds useful in explaining the up and down movements of the endogenous variables. However, the theory has nothing to say about the up and down movements of the exogenous variables. In other words, the exogenous variables are mystery variables. Changes in the exogenous variables explain changes in the endogenous variables, but the theory has no idea why the exogenous variables occasionally change in value. Ch. 16 Overview • Long-run analysis – Real variables – Nominal variables • Flexible exchange rates – We will study fixed exchange rates in Chapter 18 See subsection “The Real Exchange Rate” of Chapter 16 THE REAL EXCHANGE RATE The Real Exchange Rate • We discussed exchange rates in Chapter 14 – Example: €1 = $1.50 • Those exchange rates are nominal exchange rates • Now we’ll discuss real exchange rates The Real Exchange Rate • Let us consider the price of an iPhone in US and Europe: – In US, it is PUS = $200 – In Europe, it is PE = €150 – The value of the euro is E = 2 dollars per euro – So, Europe’s price in dollars is E × PE = $300 – So, each iPhone in Europe costs as much as 1.5 iPhones in US – E × PE / PUS = 1.5 – This is the real dollar/euro Exchange Rate for iPhones The Real Exchange Rate • In general, the real exchange rate is a broad summary measure of the prices of one country’s goods and services relative to another’s. – The real dollar/euro exchange rate is the number of US reference commodity baskets—not just iPhones— that one European reference commodity basket is worth – Equation (16-6) in KOM 10e E$ / PE q$ / PUS E$/€ is the nominal exchange rate, the price of one euro in dollars PE is the overall price level in Europe, such as the consumer price index PUS is the overall price level in the United States Depreciation and Appreciation Euro Dollar Europe’s exports America’s exports q$/€↑ Real Real More expensive Appreciation Depreciation Less expensive q$/€↓ Real Real Less expensive Depreciation Appreciation More expensive The Real Exchange Rate • Example: If the European reference commodity basket costs €100, the U.S. basket costs $120, and the nominal exchange rate is $1.20 per euro, then the real dollar/euro exchange rate (q$/€) is 1 U.S. basket per European basket. Real Depreciation and Appreciation • Real depreciation of the dollar against the euro – A rise in the real dollar/euro exchange rate (q$/€↑) • is a fall in the purchasing power of a dollar within Europe’s borders relative to its purchasing power within the United States • Or alternatively, a fall in the purchasing power of America’s products in general over Europe’s. • Real appreciation of the dollar against the euro is the opposite of a real depreciation: a fall in q$/€. This is the simplest long-run theory of the real exchange rate. It is also called the Law of One Price REAL EXCHANGE RATE IN THE LONG RUN I: ABSOLUTE PPP Absolute PPP • A very simple theory of the real exchange rate is called Absolute Purchasing Power Parity • It says that: q=1 • Why? Law of One Price • Going back for a second to the iPhone example, one can argue that PUS, the dollar price in the US, ought to be equal to E × PE, the dollar price in Europe. That is, • E × PE = PUS. • In general, E$/€ x PE = PUS. • Therefore, q$/€ = (E$/€ x PE)/PUS = 1. • This is the Law of One Price or Absolute Purchasing Power Parity. Law of One Price for Hamburgers? Some Meaty Evidence on the Law of One Price Empirical Evidence on PPP and the Law of One Price • International price comparisons typically conclude that absolute PPP is way off the mark • The prices of identical goods, when converted to a single currency, differ substantially across countries • So, we need a different theory • For that we’ll look at equilibrium in the goods market This is our second theory of the real exchange rate in the long run. Equilibrium in the markets for goods and services requires that the output of goods and services be equal to the demand for goods and services This is from Chapter 17, but let’s do it now anyway REAL EXCHANGE RATE IN THE LONG RUN II: RELATIVE PPP Determinants of Aggregate Demand • • Aggregate demand (D) is the aggregate amount of goods and services that people are willing to buy. It consists of the following types of expenditure: 1. 2. 3. 4. • consumption expenditure (C) investment expenditure (I) government purchases (G) net expenditure by foreigners: the current account (CA) So, aggregate demand for the domestic country’s output is 𝑫 = 𝑪 + 𝑰 + 𝑮 + 𝑪𝑨 16-19 The Four Components of Aggregate Demand • We need to specify the factors that determine C, I, G, and CA Determinants of Aggregate Demand • Assumption: Consumption expenditure (C) increases when disposable income (Y − T)—which is income (Y) minus taxes (T)—increases – … but by less than the increase in disposable income – Real interest rates may influence the amount of saving and consumption, but we assume that they are relatively unimportant here. – Wealth may also influence consumption, but we assume that it is relatively unimportant here. • 𝑪 = 𝑪𝟎 + 𝑪𝒚 ∙ 𝒀 − 𝑻 16-21 Determinants of Aggregate Demand • 𝐶 = 𝐶0 + 𝐶𝑦 ∙ 𝑌 − 𝑇 – 𝐶𝑦 is the Marginal Propensity to Consume. It is the increase in consumption spending when after-tax income increases by one unit. Therefore, it is a positive fraction: 0 < 𝐶𝑦 < 1 – 𝐶0 is exogenous consumption. This is what consumption spending would be when after-tax income is zero. 𝐶0 reflects the impact on consumption spending of all factors other than after-tax income. For example, 𝐶0 may change when there are changes in interest rates, households’ wealth, or consumers’ confidence 16-22 Determinants of Aggregate Demand • Both investment spending (I) and government spending (G) are assumed to be exogenous – Consequently, although the theory does discuss how changes in I and G affect endogenous variables such as Y and E, it has no idea what makes I and G fluctuate Determinants of Aggregate Demand • Assumption: The balance on the current account (CA) increases … – … when the real exchange rate (q) increases • Recall that the real exchange rate is the price of foreign products relative to the price of domestic products: q = EP*/P – … when disposable income decreases • more disposable income (Y-T) means more expenditure on foreign products (imports). Therefore, when Y−T rises, CA falls. • 𝑪𝑨 = 𝑪𝑨𝟎 + 𝑪𝑨𝒒 ∙ 𝒒 − 𝑪𝑨𝒎 ∙ 𝒀 − 𝑻 16-24 Determinants of Aggregate Demand • 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇 – 𝐶𝐴𝑞 is the increase in the domestic country’s current account when the real exchange rate increases by one unit. – Any increase (decrease) in the tariff on imported goods leads to an increase (decrease) in 𝐶𝐴𝑞 . – Note that 𝐶𝐴𝑞 > 0 16-25 Determinants of Aggregate Demand • 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇 – 𝐶𝐴𝑚 is the decrease in the domestic country’s current account (or, net exports) when after-tax income increases by one unit. When after-tax income increases by one unit, consumption spending increases by 𝐶𝑦 units. Part of this increase in consumption is imported, and this is denoted 𝐶𝐴𝑚 . – Therefore, 0 < 𝐶𝐴𝑚 < 𝐶𝑦 , which also means 𝐶𝑦 − 𝐶𝐴𝑚 > 0. 16-26 Determinants of Aggregate Demand • 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇 – 𝐶𝐴0 is exogenous net exports. – 𝐶𝐴0 reflects the impact on the domestic country’s current account of all factors other than the real exchange rate and after-tax income. – For example, 𝐶𝐴0 may increase when there is an increase in the foreign country’s GNP 16-27 Determinants of Aggregate Demand • 𝐶 = 𝐶0 + 𝐶𝑦 ∙ 𝑌 − 𝑇 • 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇 • 𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝐶𝐴 • Therefore, 𝐷 = 𝐶0 + 𝐶𝑦 ∙ 𝑌 − 𝑇 + 𝐼 + 𝐺 + 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇 Short-Run Equilibrium in the Goods Market • For the goods market to be in equilibrium, GNP must equal aggregate demand: 𝒀 = 𝑫 • Therefore, 𝐷 = 𝐶0 + 𝐶𝑦 ∙ 𝑌 − 𝑇 + 𝐼 + 𝐺 + 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇 becomes 𝒀 = 𝑪𝟎 + 𝑪𝒚 ∙ 𝒀 − 𝑻 + 𝑰 + 𝑮 + 𝑪𝑨𝟎 + 𝑪𝑨𝒒 ∙ 𝒒 − 𝑪𝑨𝒎 ∙ 𝒀 − 𝑻 • This equation represents equilibrium in the domestic country’s goods markets Y C0 C y Y T I G CA0 CAq q CAm Y T Y C0 C y Y C y T I G CA0 CAq q CAm Y CAm T Y C0 C y CAm Y C y CAm T I G CA0 CAq q Y C y CAm Y C0 C y CAm T I G CA0 CAq q 1 C y CAm Y C0 C y CAm T I G CA0 CAq q Now focus on this equation. 1 C 1 C y CAm Y C0 C y CAm T I G CA0 CAq q y CAm Y C0 C y CAm T I G CA0 CAq q Output: The Long Run • The real GNP produced when all resources are fully utilized is known by various names: – Long-run GNP – Natural GNP – Full-employment GNP – Potential GNP(Yf) • Assumption: In the long run, the economy makes full use of all its resources • Therefore, in long-run equilibrium, Y = Yf. Output: The Long Run • The full-employment output, Yf, is assumed to be exogenous • Y = Yf is what we call a solution because it expresses an endogenous variable entirely in terms of exogenous variables The Real Exchange Rate: The Long Run 1 C y CAm Y C0 C y CAm T I G CA0 CAq 1 C q q f CA Y C0 C y CAm T I G CA0 y m CAq This is the long-run value of the real exchange rate. Note that all variables on the righthand side of the equation are exogenous. Therefore, this is the solution. We cannot say anything more about the real exchange rate in the long run. Long-run predictions: The price of foreign goods (in units of domestic goods) will be higher if, in the domestic economy, either full-employment output or tax revenue is higher, or if exogenous consumption, investment, government spending or exogenous current account balance is lower. Real Exchange Rate in the Long Run • It follows that: When the supply of domestic goods increases, they will be cheaper relative to foreign goods. So, Yf↑ causes q↑. output (Yf) has a direct effect on – Full-employment the real exchange rate (q) – Taxes (T) have a direct effect too – C0 + I + G + CA0 and CAq have inverse effects on the real exchange rate (q) When the demand for domestic goods increases, they will be more expensive relative to foreign goods, causing q↓. 1 C q f CA Y C y CAm T C0 I G CA0 y m CAq Exercises • How is the real exchange rate affected in the long run by a permanent increase in: – fiscal stimulus? – money supply? – foreigners’ preference for domestic products? – tariffs on imported goods? – foreign/domestic income and household wealth? 1 C q f CA Y C y CAm T C0 I G CA0 y m CAq The Long Run and Monetary Neutrality • The macroeconomic analysis of the long run is characterized by the concept of monetary neutrality • That is, monetary arrangements and monetary policy have no effect on the behavior of real variables • Therefore, the predictions summarized on the previous slide are true for both the flexible exchange rate system of this chapter and the fixed exchange rate system of Chapter 18 The following results are true under either absolute or relative purchasing power parity FURTHER IMPLICATIONS OF PURCHASING POWER PARITY Absolute and Relative PPP • This chapter considers both Absolute PPP and Relative PPP – Absolute PPP: q = 1 – Relative PPP: q = 𝑞 a constant, not necessarily 1 • The results in the following slides are true under both APPP and RPPP Prices and the Exchange Rate • Relative PPP says: 𝑞 = • Therefore, 𝐸 = 𝑞 ∙ 𝐸∙𝑃∗ 𝑃 =𝑞 𝑃 𝑃∗ • Therefore, as 𝑞 is assumed constant in the long run, the faster domestic prices (P) grow, the faster the foreign currency’s exchange value (E) will grow • And, the faster foreign prices (P*) grow, the slower the foreign currency’s exchange value (E) will grow Prices and the Exchange Rate • In general, 𝐸𝑔 = 𝜋 − 𝜋 ∗ Equation (16-2) of the textbook, KOM 10e – where Eg is the growth rate of E. This is the appreciation rate of the foreign currency – π* is the foreign inflation rate, and – π is the domestic inflation rate • Example: If US inflation is 3% a year and Canadian inflation is 1% a year, then the exchange value of the Canadian dollar, measured in US dollars, will increase 2% a year The Interest Rate • We have seen in Chapter 15 that the interest parity equation is 𝑅 = 𝑅∗ + 𝐸 𝑒 −𝐸 𝐸 • The second term on the right-hand side is the expected appreciation rate of the foreign currency • Assumption: The expected appreciation rate is assumed to be equal to the actual appreciation rate (Eg), in the long run The Interest Rate • Therefore, 𝑅 = 𝑅 ∗ 𝐸 𝑒 −𝐸 + 𝐸 = 𝑅∗ + 𝐸𝑔 • We saw two slides earlier that 𝐸𝑔 = 𝜋 − 𝜋 ∗ • Therefore, 𝑅 = 𝑅∗ + 𝜋 − 𝜋 ∗ Equation (16-5) of the textbook, KOM 10e • Assumption: The foreign interest rate (R*) and the foreign inflation rate (π*) will be assumed to be exogenous constants The Interest Rate: Fisher Effect • 𝑅 = 𝑅∗ + 𝜋 − 𝜋 ∗ • As the foreign interest rate (R*) and the foreign inflation rate (π*) are assumed to be exogenous constants, any change in the domestic inflation rate will cause an equal change (both in magnitude and direction) in the domestic nominal interest rate • This is called the Fisher Effect – See “The Fisher Effect” in Ch. 16 of the textbook Real Interest Rate Parity • 𝑅 = 𝑅 ∗ + 𝜋 − 𝜋 ∗ implies 𝑅 − 𝜋 = 𝑅 ∗ − 𝜋 ∗ • R is the nominal interest rate. – It tells you how fast the dollar value of your wealth is increasing • R – π is the real (or, inflation-adjusted) interest rate. – It tells you how fast the purchasing power of your wealth is increasing • We now see that in the long run equilibrium, real interest rates must be equal in all countries The Interest Rate • Assumption: The domestic inflation rate (π) is constant in the long run equilibrium • Then 𝑅 = 𝑅∗ + 𝜋 − 𝜋 ∗ must also be constant in the long run equilibrium – We will now use this constancy of R to get a theory of long run inflation Inflation • We have seen in Chapter 15 that equilibrium in the money market implies 𝑀 𝑠 = 𝑀𝑑 • Moreover, 𝑀𝑑 = 𝑃 ∙ 𝐿(𝑅, 𝑌) 𝑑 • Simplifying a bit, 𝑀 = 𝑃∙𝐿0 ∙𝑌 𝑅 𝑠 • Therefore, in equilibrium, 𝑀 = • Therefore, 𝑃 = 𝑀𝑠 ∙𝑅 𝐿0 ∙𝑌 𝑃∙𝐿0 ∙𝑌 𝑅 Inflation • Therefore, in the long-run, 𝑃 = 𝑀𝑠 ∙𝑅 𝐿0 ∙𝑌 = 𝑀𝑠 ∙𝑅 𝐿0 ∙𝑌 𝑓 • We saw three slides back that R is constant in the long run equilibrium. Moreover, L0 is an exogenous constant • Therefore, the faster the money supply (Ms) grows, the faster the price level (P) will grow • And, the faster potential GDP (Yf) grows, the slower the price level (P) will grow Inflation • In general, 𝜋 = 𝑀 𝑠𝑔 − 𝑌𝑓𝑔 – Note that this is a solution because it expresses an endogenous variable, π, entirely in terms of exogenous variables • For example, if the Federal Reserve expands US money supply at the rate of 5% a year and if the US economy’s potential GDP increases at the rate of 3% a year, then, in the long run, the US inflation rate will be 2% a year. The Interest Rate, again • So far, we have shown that – 𝑅 = 𝑅 ∗ + 𝐸𝑔 (interest parity), – 𝐸𝑔 = 𝜋 − 𝜋 ∗ , and – 𝜋 = 𝑀 𝑠𝑔 − 𝑌𝑓 𝑔 • Therefore, the domestic nominal interest rate in the long run is 𝑅 = 𝑅∗ + 𝑀 𝑠𝑔 − 𝑌𝑓𝑔 − 𝜋 ∗ , a constant – Note that this is a solution because it expresses an endogenous variable, R, entirely in terms of exogenous variables The Price Level • A few slides back, we saw that in the long run the domestic price level is 𝑃 = 𝑀𝑠 ∙𝑅 𝐿0 ∙𝑌 𝑓 ∗ • Moreover, we just saw that 𝑅 = 𝑅 + 𝑀 𝑠𝑔 − 𝑌𝑓𝑔 − 𝜋 ∗ • Therefore, in the long run, the domestic price level is 𝑃 = 𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ 𝐿0 ∙𝑌 𝑓 Appreciation Rate of the Foreign Currency • We saw earlier that – the foreign currency appreciates at the rate 𝐸𝑔 = 𝜋 − 𝜋 ∗ , and – the inflation rate is 𝜋 = 𝑀 𝑠𝑔 − 𝑌𝑓𝑔 , • Therefore, 𝐸𝑔 = 𝑀 𝑠𝑔 − 𝑌𝑓𝑔 − 𝜋 ∗ – Note that this is a solution because it expresses an endogenous variable, Eg, entirely in terms of exogenous variables The Exchange Rate • Recall that under relative purchasing power parity, we have 𝑞 = 𝐸=𝑞∙ 𝑃 𝑃∗ 𝐸∙𝑃∗ 𝑃 = 𝑞, which implies • We have also seen two slides back that 𝑃 = 𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ 𝐿0 ∙𝑌 𝑓 • Therefore, 𝐸 = 𝑞∙𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ 𝐿0 ∙𝑌 𝑓 ∙𝑃∗ Summary: Long-Run, Flexible Exchange Rates • q = 𝑞, relative PPP • Y = Yf • 𝜋 = 𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔 • 𝑅 = 𝑅 ∗ + 𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔 − 𝜋 ∗ • 𝑃= 𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ • 𝐸𝑔 = • 𝐸= 𝐿0 ∙𝑌 𝑓 𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔 − 𝜋∗ 𝑞∙𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ 𝐿0 ∙𝑌 𝑓 ∙𝑃∗ The crucial point to note about these expressions is that the variables on the right-hand sides of these equations are all exogenous. As exogenous variables are ‘mystery variables’ about which our theory has nothing to say, the equations on this slide say all that our theory can say about the endogenous variables on the left-hand sides of these equations. Summary: Long-Run, Flexible Exchange Rates • q = 𝑞, relative PPP • Y = Yf • 𝜋 = 𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔 • 𝑅 = 𝑅 ∗ + 𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔 − 𝜋 ∗ • 𝑃= 𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ • 𝐸𝑔 = • 𝐸= 𝐿0 ∙𝑌 𝑓 𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔 − 𝜋∗ 𝑞∙𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ 𝐿0 ∙𝑌 𝑓 ∙𝑃∗ Keep in mind that we are talking about the long run here. So, these equations show us the long run effects of permanent changes in the exogenous variables on the equations’ right-hand sides. Summary: Long-Run, Flexible Exchange Rates • q = 𝑞, relative PPP • Y = Yf • 𝜋 • 𝑅 The first two variables are real variables: they can be measured even in barter (or, non-monetary) 𝑠 𝑓 =𝑀 𝑔−𝑌 𝑔 economies. The remaining variables are nominal variables: they make ∗ 𝑠 𝑓 ∗ = 𝑅 + 𝑀 𝑔 − 𝑌 𝑔 − 𝜋 sense only on monetary economies. • 𝑃= 𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ • 𝐸𝑔 = • 𝐸= 𝐿0 ∙𝑌 𝑓 𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔 − 𝜋∗ 𝑞∙𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ 𝐿0 ∙𝑌 𝑓 ∙𝑃∗ Note that the money supply (Ms) has no effect on real variables. This is an instance of monetary neutrality in the long run. Summary: Long-Run, Flexible Exchange Rates • q = 𝑞, relative PPP • Y = Yf Flashback to Ch. 15 of the textbook (KOM 10e): • 𝜋 = 𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔 • 𝑅= • 𝑃= “A change in the supply of money has no effect on the long-run values of the ∗ 𝑠 𝑓 ∗ 𝑅 + 𝑀 𝑔 − 𝑌 𝑔 − 𝜋 interest rate or real output.” (p. 395) 𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ 𝐿0 ∙𝑌 𝑓 • 𝐸𝑔 = 𝑀 𝑠𝑔 − 𝑌𝑓𝑔 − 𝜋 ∗ • 𝐸= 𝑞∙𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ 𝐿0 ∙𝑌 𝑓 ∙𝑃∗ “A permanent increase in the money supply causes a proportional increase in the price level’s long-run value. In particular, if the economy is initially at full employment, a permanent increase in the money supply eventually will be followed by a proportional increase in the price level.” (p. 396) Summary: Long-Run, Flexible Exchange Rates • q = 𝑞, relative PPP • Y = Yf Recall that: 1 C q • 𝜋 = 𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔 • 𝑅= • 𝑃= 𝑅∗ 𝑔 − 𝑌𝑓 𝑔 − 𝜋∗ 𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ • 𝐸𝑔 = • 𝐸= + 𝑀𝑠 𝐿0 ∙𝑌 𝑓 𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔 − 𝜋∗ 𝑞∙𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗ 𝐿0 ∙𝑌 𝑓 ∙𝑃∗ y CAm Y f C y CAm T C0 I G CA0 CAq Therefore, the effect of fullemployment output (Yf) on the foreign currency’s value (E) is ambiguous. Why? When full-employment output increases, both the numerator and the denominator of the equation for E increase. So, the effect on E is indeterminate. Exercises • What are long-run effects of expansionary fiscal policy (G↑ and/or T↓) under flexible exchange rates? • What are long-run effects of expansionary monetary policy (Ms↑) under flexible exchange rates? • What are the effects of an increase in R*− π*? • What are the effects of an increase in P*? The balance on a country’s current account (CA) is roughly its net exports What does CA depend on in the long run? BONUS TOPIC: THE CURRENT ACCOUNT IN THE LONG RUN The Current Account: The Long Run • Recall that the goods market is in equilibrium when 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝐶𝐴 – Therefore, 𝐶𝐴 = 𝑌 − 𝐶 − 𝐼 − 𝐺 – 𝐶 = 𝐶0 + 𝐶𝑦 ∙ 𝑌 − 𝑇 and 0 < 𝐶𝑦 < 1 – 𝑌 = 𝑌𝑓 in the long run – C0, Cy, I, G, T, and Yf are exogenous • So, 𝐶𝐴 = 1 − 𝐶𝑦 ∙ 𝑌𝑓 − 𝐶0 + 𝐶𝑦 ∙ 𝑇 − 𝐼 − 𝐺 The Current Account: The Long Run • 𝐶𝐴 = 1 − 𝐶𝑦 ∙ 𝑌𝑓 − 𝐶0 + 𝐶𝑦 ∙ 𝑇 − 𝐼 − 𝐺 • As 0 < 𝐶𝑦 < 1, it follows that 1 − 𝐶𝑦 > 0 • It follows that in the long run, CA is – directly related with and T, and – inversely related with C0, I and G Yf CA Yf, T + C0, I, G − • The key things are domestic supply and demand. When domestic supply increases or domestic demand decreases, net exports increases. The Current Account: The Long Run • Contractionary fiscal policy or “fiscal austerity” (T↑ or G↓) is a way to raise a country’s net exports (CA↑) • A fall in consumer wealth—caused by, say, a real estate crash or a stock market crash—reduces C0 and therefore leads to an increase in CA! • Monetary policy has no effect • Tariffs on imports have no effect! CA Yf, T + C0, I, G − The Long Run and Monetary Neutrality • The macroeconomic analysis of the long run is characterized by the concept of monetary neutrality • That is, monetary arrangements and monetary policy have no effect on the behavior of real variables • Therefore, the predictions summarized by the table on this slide are true for both the flexible exchange rate system of this chapter and the fixed exchange rate system of Chapter 18 CA Yf, T + C0, I, G −