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(Y d ) - PowerPoint PPT Presentation
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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 increasesValue effect: we pay more in real terms (in units of domestic
product) for the imports we do buy when q increasesWe assume that the volume effect of a real exchange rate change
outweighs the value effect: q up CA “improves”.
Determinants of Aggregate Demand in an Open Economy
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.
where: Ee is the expected future exchange rateR is the interest rate on domestic currency depositsR* is the interest rate on foreign currency deposits
Money Market equilibriumMs/P = L(R, Y)
AA Schedule: combinations of exchange rate and output that are consistent with asset market equilibrium (the domestic money market and the foreign exchange market).
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)
• 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
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 Supplyexpected 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
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.
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).
The J-Curve: if imports and exports adjust gradually to real exchange rate changes, the CA may follow a J-curve 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.
Gradual Trade Flow Adjustment and Current Account Dynamics
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.
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.
Appendix III: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities Table 16AIII-1: Estimated Price Elasticities for International Trade