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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 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”.
Determinants of Aggregate Demand in an Open Economy
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
Output Market Equilibrium in the Short Run: The DD Schedule
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.
R = R* + (Ee – E)/Ewhere: 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)
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)
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.