Chapter 17(2)

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 17

Output and the Exchange Rate in 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 & firms throughout the world.

• Aggregate demand for an open economy’s output is the sum of consumption demand (C), investment demand (I), government demand (G) and net export demand (the current account, CA).

• Each of these components depends on various factors.

2

1. Determinants of consumption demand

• A country’s desired consumption can be written as a function of disposable income.

C = C(Yd)

Yd = disposable income (national income less taxes, Y – T).

• We expect C to increase as disposable income increases.

• Consumption demand and Yd are positively related.

• When Yd rises, consumption demand generally rises by less than the rise in consumption, because part of the income increase is saved.

3

2. Determinants of the Current Account

• The current account balance (CA): the demand for a country’s exports less the country’s own demand for imports.

• CA = EX – IM

EX = exports

IM = imports

• CA is determined by 2 factors:

- the domestic currency’s real exchange rate against foreign currency

- the domestic disposable income.

4

• We express a country’s current account balance.

CA = CA (EP*/P, Yd)

EP*/P = the real exchange rate of that country’s currency.

It is the price of the foreign basket in terms of the domestic one.

Yd = disposable income

Note

EP* = the domestic currency prices of the representative foreign expenditure basket.

P = the domestic currency prices of the representative domestic expenditure basket.

E = the price of foreign currency in terms of domestic currency.

P* = the foreign price level.

P = the home price level.

5

3. How Real Exchange Rate Changes affect the Current Account

• CA = EX – IM

EX = exports

IM = imports

• Suppose EP*/P rises, other things equal.

• How does the rise in EP*/P affect EX?

• Foreign products have become more expensive relative to domestic products.

• Each unit of domestic output now purchases fewer units of foreign output.

• Foreign consumers will respond to this by demanding more of the domestic country’s output.

• EX will increase.

• The domestic country’s current account will be better off.6

• How does the rise in EP*/P affect IM?

• There are two effects working when EP*/P rises.

1) the volume effect the volume of goods imported decreases when EP*/P rises.

2) the value effect the value of imports measured in terms of domestic output now increases.

• The effect of an increase in EP*/P on IM is ambiguous.

• For simplicity, we assume that the volume effect outweighs the value effect.

• So when EP*/P increases, IM decreases, and CA is better.

• And when EP*/P decreases, IM increases, and CA is worse.

• Our simplifying assumptions are: a real depreciation of the domestic currency improves the current account, and a real appreciation of the currency worsen the current account.

7

3. How Disposable Income Changes affect the Current Account

• Suppose Yd increases

• Domestic consumers increase their spending on all goods, including imports from abroad.

• An increase in Yd worsens the current account.

• A decrease in Yd, decreases spending on imports, and the current account improves.

• The effects on the CA are summarized in Table 17-1.

8

Table 17-1: Factors Determining the Current Account

9

The Equation of Aggregate Demand

D = C(Y – T) + I + G + CA(EP*/P, Y – T)

where

Yd = Y – T

Y = output

T = taxes

• The equation can be rewritten as

D = D(EP*/P, Y – T, I, G)

10

1. The Real Exchange Rate and Aggregate Demand

• A rise in EP*/P makes domestic goods and services cheaper relative to foreign goods and services, and shifts both domestic and foreign spending from foreign goods to domestic goods.

• As a result CA rises, and aggregate demand goes up.

• A real depreciation of the home currency raises aggregate demand for home output, other things equal.

• A real appreciation of the home currency lowers aggregate demand for home output, other things equal.

11

2. Real Income and Aggregate Demand

• When Yd increases, consumption increases (AD↑).

• When Yd increases imports increase, this worsens CA (AD).

• The first effect is stronger than the second effect.

• A rise in domestic real income raises aggregate demand for home output, other things equal.

• A fall in domestic real income lowers aggregate demand for home output, other things equal.

12

• Figure 17-1 shows the relation between aggregate demand and real income for fixed values of the real exchange rate, taxes, investment demand, and government spending.

• A rise in output, Y, increases aggregate demand.

• Because the increase in aggregate demand is less than the increase in output, the slope of the aggregate demand function is less than 1.

• As Y rises, consumption rises by a fraction of the increase in income.

• Part of this increase in consumption goes into import spending.

• The schedule starts above the origin because I, G and EX would make aggregate demand greater than zero, if Y = 0.

13

Figure 17-1: Aggregate Demand as a Function of Output

14

How Output is Determined in the Short Run.

• The output market is in equilibrium when real domestic output, Y, equals the aggregate demand for domestic output.

Y = D(EP*/P, Y – T, I, G)

• This equality determines the short run equilibrium output level.

• We are talking about the short run.

• We assume prices of goods & services are temporarily fixed.

• The determination of national output in the short run is illustrated in Figure 17-2.

• The 450 line drawn from the origin represents the equation D = Y.

• Y1 is the unique output level where aggregate demand equals domestic output.

15

Figure 17-2: The Determination of Output in the Short Run

16

• At point 2, AD > Y, there is excess demand. Firms respond by producing more, output expands until national income reaches Y1.

• At point 3, Y > AD, there is excess supply, inventories build up. Firms produce less. Output falls to Y1.

17

Output Market Equilibrium in the Short Run: The DD Schedule

1. Output, the Exchange Rate and Output Market Equilibrium

• See Figure 17-3. It shows the relationship between the exchange rate and equilibrium output.

• Suppose the domestic currency depreciates, everything else equal. (E increases).

• How does this affect equilibrium output?

• Foreign goods and services become expensive relative to home goods & services.

• Exports increase and imports decrease.

• Current account is better.

• Aggregate demand shifts up.

• Equilibrium output increases.18

Figure 17-3: Output Effect of a Currency Depreciation with Fixed Output Prices

19

• A change in the real exchange rate EP*/P, can happen when E or P* or P changes.

• Any rise in the real exchange rate (whether due to a rise in E, a rise in P*, or a fall in P) will cause an upward shift in the aggregate demand function and an expansion of output, all else equal.

• Any fall in EP*/P (whether due to a fall in E, a fall in P*, or a rise in P) will cause a downward shift in the aggregate demand function, and a contraction of output, all else equal.

20

2. Deriving the DD Schedule

• Assume P and P* are fixed in the short run.

• When E, rises, domestic output increases.

• When E falls domestic output decreases.

• The DD schedule: shows all combinations of output and exchange rate for which the output market is in equilibrium (aggregate demand = aggregate output).

• See Figure 7-4.

• When the exchange rate increases, output increases.

21

Figure. 17-4: Deriving the DD Schedule

22

3. Factors that shift the DD schedule

1) A change in G

An increase in G, all else equal, causes the aggregate demand function to shift upward, and causes the DD curve to shift to the right.

A decrease in G, all else equal, causes the aggregate demand function to shift downward, and causes the DD curve to shift to the left.

See Figure 17-5.

2) A change in T

Taxes affect aggregate demand by changing disposable income, and consumption, for any level of Y.

A increase in taxes will cause the aggregate demand to shift down. So output decreases.

An increase in T (all else equal), will cause the aggregate demand function to shift downward, and will cause the DD schedule to shift to the left.

A fall in the T (all else equal), will cause the aggregate demand function to shift upward, and will cause the DD schedule to shift to the right. 23

Figure 17-5: Government

Demand and the Position of the DD

Schedule

24

3) A change in I

An increase in I (all else equal) will cause the aggregate demand function to shift upward, and will cause the DD schedule to shift to the right.

A decrease in I (all else equal) will cause the aggregate demand function to shift downward, and will cause the DD schedule to shift to the left.

25

4) A change in P

An increase in P, all else equal will make the domestic output more expensive relative to foreign output. Exports decrease, and imports increase. Net exports are less (CA is worse).

A rise in P (all else equal) will cause the aggregate demand function to shift down, and will cause the DD schedule to shift to the left.

A fall in P (all else equal) will cause the aggregate demand function to shift up, and will cause the DD schedule to shift to the right.

5) A change in P*

An rise in P* (all else equal), will cause the aggregate demand function to shift to the upward, and will cause the DD schedule to shift to the right.

A fall in P* (all else equal) will cause the aggregate demand function to shift upward, and will cause the DD schedule to shift to the left.

26

6) A change in the consumption function

Suppose residents of the home country decide that they want to consume more and save less at every level of income. (MPC

). We assume that the increase in consumption is not devoted entirely to imports from abroad.

A rise in consumption (all else equal) will cause aggregate demand to shift upward, and will cause the DD curve to shift to the right.

A fall in consumption (all else equal) will cause aggregate demand to shift downward, and will cause the DD curve to shift to the left.

27

7) A demand shift between domestic and foreign goods

Suppose domestic and foreign residents suddenly decide to devote more of their spending on goods and services produced in the home country. (exports , imports , the current account improves) the aggregate demand function will shift up.

• If there is a shift in demand toward domestic goods (Ex , Im ), all else equal, the aggregate demand function will shift upward, and the DD curve will shift to the right.

• If there is a shift in demand toward foreign goods (Ex , Im ), all else equal, the aggregate demand function will shift downward, and the DD curve will shift to the left.

28

Conclusion:

Any disturbance that raises aggregate demand for domestic output shifts the DD schedule to the right.

Any disturbance that lowers aggregate demand for domestic output shifts the DD schedule to the left.

29

Asset Market Equilibrium in the Short Run: The AA Schedule

• The AA Schedule: the schedule of exchange rate and output combinations that are consistent with equilibrium in the domestic money market and the foreign exchange market.

30

1. Output, the Exchange Rate and Asset Market Equilibrium

• We will see how the exchange rate and output must be related when all asset markets simultaneously clear.

• By asset markets, we mean the money market and the foreign exchange market

• Because our focus on the domestic economy, the foreign interest rate is taken as given.

• See Figure 17-6. It shows the equilibrium domestic interest rate and exchange rate.

• This figure shows equilibrium in the money market and equilibrium in the foreign exchange market.

• A rise in output, raises real aggregate money demand. So the domestic interest rate goes up. So the domestic currency appreciates.

31

Fig. 17-6: Output and the Exchange Rate in

Asset Market Equilibrium

32

• For asset markets to remain in equilibrium, a rise in domestic output must be accompanied by an appreciation of the domestic currency, all else equal.

• For asset markets to remain in equilibrium, a fall in domestic output must be accompanied by a depreciation of the domestic currency, all else equal.

33

2. Deriving the AA Schedule

• The AA schedule relates exchange rates and output levels that keep the money and foreign exchange markets in equilibrium.

• Figure 17-7 shows the AA schedule.

• The AA schedule is downward sloping.

34

Figure 17-7: The AA Schedule

35

3. Factors that shift the AA Schedule

• A change in MS.

An increase in MS (all else equal) causes the domestic currency to depreciate in the foreign exchange market. So the AA schedule will shift upward.

• A rise in MS causes the AA schedule to shift upward.

• A fall in MS causes the AA schedule to shift downward.

2. A change in P

An increase in P (all else equal) reduces real money supply, and drives the domestic interest rate upward. E falls, the domestic currency appreciates. The AA curve shifts downward.

• An increase in P (all else equal), results in a downward shift in AA.

• A decrease in P (all else equal), results in an upward shift in AA.

36

3. A change in Ee

Suppose Ee rises.

The curve on the top part of Figure 17-6 will shift up (the expected rate of return on foreign deposits increases).

E will increase. (The domestic currency will depreciate.)

The AA curve will shift upward.

• When Ee rises (all else equal), the AA curve will shift upward.

• When Ee falls (all else equal), the AA curve will shift downward.

37

4. A change in R*

Suppose R* rises.

The curve on the top part of Figure 17-6 will shift up. E will increase (the domestic currency depreciates). The AA curve will shift upward.

• When R* rises (all else equal), the AA curve will shift upward.

• When R* falls (all else equal), the AA curve will shift downward.

38

5. A change in money demand

• Suppose domestic residents increase their money demand. L(R,Y) shifts outward, the domestic interest rate increases, and E falls. So the AA curve shifts down.

When money demand rises (all else equal), the AA curve shifts downward.

When money demand falls, (all else equal) the AA curve shifts upward.

39

Short-Run Equilibrium for an Open Economy:

Putting the DD and AA schedules together.

• A short-run equilibrium for the economy as a whole must lie on both schedules. Such a point must bring about equilibrium simultaneously in the output and asset markets.

• We can find the economy’s short-run equilibrium by finding the intersection of the DD & AA schedules.

• See Figure 17-8. It combines the DD & AA schedules, to locate short-run equilibrium.

• See Figure 17-9.

• The economy will adjust itself and go to point 1.

40

Figure 17-8: Short-Run Equilibrium: The Intersection of DD and AA

41

Figure 17-9: How the Economy Reaches Its Short-Run Equilibrium

42

Temporary Changes in Monetary or Fiscal Policy

• We can study how shifts in government macroeconomic policies affect output and the exchange rate.

• Monetary policy: government policy which works through changes in money supply.

• Fiscal policy: government policy which works through government spending or taxation.

• For simplicity, we will look at one-shot increases or decreases in money supply.

• Temporary policy shifts: shifts that the public expects to be reversed in the near future.

43

1. Monetary Policy


• Suppose there is an increase in domestic money supply.

• The AA curve shifts up.

• The DD curve is not affected.

• The domestic currency depreciates, the domestic output expands, and there is an increase in employment.

• An increase in money supply (all else equal) causes a depreciation of the domestic currency and an expansion of output.

• A decrease in money supply (all else equal) causes an appreciation of the domestic currency and a contraction of output.

44

Figure 17-10: Effects of a Temporary Increase in the Money Supply

45

2. Fiscal Policy

• Expansionary fiscal policy can take the form of an increase in government spending, a cut in taxes, or some combination of the two that raises aggregate demand.

• A temporary fiscal expansion shifts the DD schedule to the right, but does not affect the AA schedule.


• Output increases, and the domestic currency appreciates.

• Expansionary fiscal policy (all else equal) causes the output to increase, and the domestic currency to appreciate.

• Contractionary fiscal policy (all else equal) causes the output to fall, and the domestic currency to depreciate.

46

Figure 17-11: Effects of a Temporary Fiscal Expansion

47

3. Policies to Maintain Full Employment

• Temporary monetary expansion and temporary fiscal expansion raise output and employment. These policies can be used to counteract the effects of temporary disturbances that lead to a recession.

• Disturbances that lead to overemployment can be offset through contractionary macroeconomic policies.

48


• Suppose the economy’s initial equilibrium is at point 1, where output is at its full-employment level (Yf).

• Suddenly there is a temporary change in consumer tastes, away from domestic products.

• The aggregate demand function shifts down.

• The DD schedule shifts to the left (to DD2).

• The new short run equilibrium is at point 2.

• The economy is in a recession: output is below its full-employment level.

• The shift in preferences is assumed to be temporary, it does not affect Ee, so there is no change in the position of AA.

49

• To restore full employment, the government may use monetary policy or fiscal policy or both.

• A temporary fiscal expansion will shift DD2 back to its equilibrium position, restoring full employment and returning the exchange rate to E1.


• A temporary increase in money supply shifts the AA curve upwards (to AA2), and places the economy at point 3.

• Full employment is restored, but the domestic currency depreciates even further.

50

Figure 17-12: Maintaining Full Employment After a Temporary Fall in World Demand for Domestic Products

51


• Another cause for a recession is a temporary increase in the demand for money.

• Suppose there is a temporary increase in the demand for money.

• The domestic interest rate increases.

• The domestic currency appreciates.

• Domestic goods become more expensive and the output contracts.

• The AA curve shifts from AA1 to AA2.

• The economy moves from point 1 to point 2.

• A temporary money supply increase shifts the AA curve to AA1 and moves the economy back to point 1.

• A temporary fiscal expansion shifts the DD curve from DD1 to DD2, and restores full employment at point 3.

• The move to point 3 involves a greater appreciation of the currency.

52

Figure 17-13: Policies to Maintain Full Employment After a Money Demand Increase

53