Chapter 16 Output And The Exchange Rate In The Short Run
Chapter 16Output and the Exchange Rate in the Short RunPrepared by Iordanis PetsasTo AccompanyInternational Economics: Theory and Policy,Policy Sixth Editionby Paul R. Krugman and Maurice Obstfeld
Chapter Organization Determinants of Aggregate Demand in an Open EconomyThe Equation of Aggregate DemandHow Output Is Determined in the Short RunOutput Market Equilibrium in the Sort Run: The DDScheduleAsset Market Equilibrium in the Short Run: The AAScheduleShort-Run Equilibrium for an Open Economy:Putting the DD and AA Schedules TogetherCopyright 2003 Pearson Education, Inc.Slide 16-2
Chapter Organization Temporary Changes in Monetary and Fiscal Policy Inflation Bias and Other Problems of Policy FormulationPermanent Shifts in Monetary and Fiscal PolicyMacroeconomic Policies and the Current AccountGradual Trade Flow Adjustment and Current AccountDynamicsSummaryCopyright 2003 Pearson Education, Inc.Slide 16-3
Chapter Organization Appendix I: The IS-LM Model and the DD-AA Model Appendix II: Intertemporal Trade and Consumption DemandAppendix III: The Marshall-Lerner Condition andEmpirical Estimates of Trade ElasticitiesCopyright 2003 Pearson Education, Inc.Slide 16-4
Introduction Macroeconomic changes that affect exchange rates,interest rates, and price levels may also affect output. This chapter introduces a new theory of how theoutput market adjusts to demand changes whenproduct prices are themselves slow to adjust. A short-run model of the output market in an openeconomy will be utilized to analyze: The effects of macroeconomic policy tools on outputand the current account The use of macroeconomic policy tools to maintainfull employmentCopyright 2003 Pearson Education, Inc.Slide 16-5
Determinants of AggregateDemand in an Open Economy Aggregate demand The amount of a country’s goods and servicesdemanded by households and firms throughout theworld. The aggregate demand for an open economy’s outputconsists of four components: Consumption demand (C)Investment demand (I)Government demand (G)Current account (CA)Copyright 2003 Pearson Education, Inc.Slide 16-6
Determinants of AggregateDemand in an Open Economy Determinants of Consumption Demand Consumption demand increases as disposable income(i.e., national income less taxes) increases at theaggregate level.– The increase in consumption demand is less than theincrease in the disposable income because part of theincome increase is saved.Copyright 2003 Pearson Education, Inc.Slide 16-7
Determinants of AggregateDemand in an Open Economy Determinants of the Current Account The CA balance is viewed as the demand for acountry’s exports (EX) less that country's own demandfor imports (IM). The CA balance is determined by two main factors:– The domestic currency’s real exchange rate againstforeign currency (q EP*/P)– Domestic disposable income (Yd)Copyright 2003 Pearson Education, Inc.Slide 16-8
Determinants of AggregateDemand in an Open Economy How Real Exchange Rate Changes Affect the CurrentAccount An increase in q raises EX and improves the domesticcountry’s CA.– Each unit of domestic output now purchases fewer unitsof foreign output, therefore, foreign will demand moreexports. An increase q can raise or lower IM and has anambiguous effect on CA.– IM denotes the value of imports measured in terms ofdomestic output.Copyright 2003 Pearson Education, Inc.Slide 16-9
Determinants of AggregateDemand in an Open Economy There are two effects of a real exchange rate: Volume effect– The effect of consumer spending shifts on export andimport quantities Value effect– It changes the domestic output worth of a given volumeof foreign imports. Whether the CA improves or worsens depends on which effect of a real exchange rate change isdominant.We assume that the volume effect of a real exchangerate change always outweighs the value effect.Copyright 2003 Pearson Education, Inc.Slide 16-10
Determinants of AggregateDemand in an Open Economy How Disposable Income Changes Affect the CurrentAccount An increase in disposable income (Yd) worsens the CA. A rise in Yd causes domestic consumers to increasetheir spending on all goods.Copyright 2003 Pearson Education, Inc.Slide 16-11
Determinants of AggregateDemand in an Open EconomyTable 16-1: Factors Determining the Current AccountCopyright 2003 Pearson Education, Inc.Slide 16-12
The Equation of Aggregate Demand The four components of aggregate demand are combined to get the total aggregate demand:D C(Y – T) I G CA(EP*/P, Y – T)This equation shows that aggregate demand for homeoutput can be written as:D D(EP*/P, Y – T, I, G)Copyright 2003 Pearson Education, Inc.Slide 16-13
The Equation of Aggregate Demand The Real Exchange Rate and Aggregate Demand An increase in q raises CA and D.– It makes domestic goods and services cheaper relativeto foreign goods and services.– It shifts both domestic and foreign spending fromforeign goods to domestic goods.– A real depreciation of the home currency raisesaggregate demand for home output.– A real appreciation lowers aggregate demand for home output.Copyright 2003 Pearson Education, Inc.Slide 16-14
The Equation of Aggregate Demand Real Income and Aggregate Demand A rise in domestic real income raises aggregatedemand for home output. A fall in domestic real income lowers aggregatedemand for home output.Copyright 2003 Pearson Education, Inc.Slide 16-15
The Equation of Aggregate DemandFigure 16-1: Aggregate Demand as a Function of OutputAggregatedemand, DAggregate demand function,D(EP*/P, Y – T, I, G)45 Output (real income), YCopyright 2003 Pearson Education, Inc.Slide 16-16
How Output IsDetermined in the Short Run Output market is in equilibrium in the short-run whenreal output, Y, equals the aggregate demand fordomestic output:Y D(EP*/P, Y – T, I, G)(16-1)Copyright 2003 Pearson Education, Inc.Slide 16-17
How Output IsDetermined in the Short RunFigure 16-2: The Determination of Output in the Short RunAggregatedemand, DAggregate demand aggregate output, D YAggregate demandD113Y1Y3245 Y2Copyright 2003 Pearson Education, Inc.Output, YSlide 16-18
Output Market Equilibrium in theShort Run: The DD Schedule Output, the Exchange Rate, and Output MarketEquilibrium With fixed price levels at home and abroad, a rise inthe nominal exchange rate makes foreign goods andservices more expensive relative to domestic goodsand services.– Any rise in q will cause an upward shift in the aggregatedemand function and an expansion of output.– Any fall in q will cause output to contract.Copyright 2003 Pearson Education, Inc.Slide 16-19
Output Market Equilibrium in theShort Run: The DD ScheduleFigure 16-3: Output Effect of a Currency Depreciation with FixedOutput PricesAggregatedemand, DD YCurrencydepreciates2Aggregate demand (E2)Aggregate demand (E1)145 Copyright 2003 Pearson Education, Inc.Y1Y2Output, YSlide 16-20
Output Market Equilibrium in theShort Run: The DD Schedule Deriving the DD Schedule DD schedule– It shows all combinations of output and the exchangerate for which the output market is in short-runequilibrium (aggregate demand aggregate output).– It slopes upward because a rise in the exchange ratecauses output to rise.Copyright 2003 Pearson Education, Inc.Slide 16-21
Output Market Equilibrium in theShort Run: The DD ScheduleFigure 16-4: Deriving the DD ScheduleAggregate demand, DD YAggregate demand (E2)Aggregate demand (E1)Exchange rate, EY1Copyright 2003 Pearson Education, Inc.Output, YDDE2E1Y221Y1Y2Output, YSlide 16-22
Output Market Equilibrium in theShort Run: The DD Schedule Factors that Shift the DD Schedule Government purchasesTaxesInvestmentDomestic price levelsForeign price levelsDomestic consumptionDemand shift between foreign and domestic goods A disturbance that raises (lowers) aggregate demand fordomestic output shifts the DD schedule to the right (left).Copyright 2003 Pearson Education, Inc.Slide 16-23
Output Market Equilibrium in theShort Run: The DD ScheduleFigure 16-5: Government Demand and the Position of the DD ScheduleAggregate demand, DGovernmentspending risesD YD(E0P*/P, Y – T, I, G2)Aggregate demand curvesD(E0P*/P, Y – T, I, G1)Y1Exchange rate, EY2Output, YDD1DD2E0Copyright 2003 Pearson Education, Inc.12Y1Y2Output, YSlide 16-24
Asset Market Equilibrium in theShort Run: The AA Schedule AA Schedule It shows all combinations of exchange rate and outputthat are consistent with equilibrium in the domesticmoney market and the foreign exchange market.Copyright 2003 Pearson Education, Inc.Slide 16-25
Asset Market Equilibrium in theShort Run: The AA Schedule Output, the Exchange Rate, and Asset MarketEquilibrium We will combine the interest parity condition with themoney market to derive the asset market equilibriumin the short-run. The interest parity condition describing foreignexchange market equilibrium is:R R* (Ee – E)/Ewhere: Ee is the expected future exchange rateR is the interest rate on domestic currency depositsR* is the interest rate on foreign currency depositsCopyright 2003 Pearson Education, Inc.Slide 16-26
Asset Market Equilibrium in theShort Run: The AA Schedule The R satisfying the interest parity condition must alsoequate the real domestic money supply to aggregatereal money demand:Ms/P L(R, Y) Aggregate real money demand L(R, Y) rises when theinterest rate falls because a fall in R makes interestbearing nonmoney assets less attractive to hold.Copyright 2003 Pearson Education, Inc.Slide 16-27
Asset Market Equilibrium in theShort Run: The AA ScheduleFigure 16-6: Output and the Exchange Rate in Asset Market EquilibriumExchange Rate, EForeignexchangemarket0Moneymarket1'E1E22'R1 R2Domestic-currencyreturn on foreigncurrency deposits Domesticinterestrate, RL(R, Y1)L(R, Y2)MSPOutput rises12Real moneysupplyReal domestic money holdingsCopyright 2003 Pearson Education, Inc.Slide 16-28
Asset Market Equilibrium in theShort Run: The AA Schedule For asset markets to remain in equilibrium: A rise in domestic output must be accompanied by anappreciation of the domestic currency. A fall in domestic output must be accompanied by adepreciation of the domestic currency.Copyright 2003 Pearson Education, Inc.Slide 16-29
Asset Market Equilibrium in theShort Run: The AA Schedule Deriving the AA Schedule It relates exchange rates and output levels that keep themoney and foreign exchange markets in equilibrium. It slopes downward because a rise in output causes arise in the home interest rate and a domestic currencyappreciation.Copyright 2003 Pearson Education, Inc.Slide 16-30
Asset Market Equilibrium in theShort Run: The AA ScheduleFigure 16-7: The AA ScheduleExchangeRate, EE112E2AAY1Copyright 2003 Pearson Education, Inc.Y2Output, YSlide 16-31
Asset Market Equilibrium in theShort Run: The AA Schedule Factors that Shift the AA Schedule Domestic money supplyDomestic price levelExpected future exchange rateForeign interest rateShifts in the aggregate real money demand scheduleCopyright 2003 Pearson Education, Inc.Slide 16-32
Short-Run Equilibrium for an Open Economy:Putting the DD and AA Schedules Together A short-run equilibrium for the economy as a wholemust bring equilibrium simultaneously in the outputand asset markets. That is, it must lie on both DD and AA schedules.Copyright 2003 Pearson Education, Inc.Slide 16-33
Short-Run Equilibrium for an Open Economy:Putting the DD and AA Schedules TogetherFigure 16-8: Short-Run Equilibrium: The Intersection of DD and AAExchangeRate, EE1DD1AAY1Copyright 2003 Pearson Education, Inc.Output, YSlide 16-34
Short-Run Equilibrium for an Open Economy:Putting the DD and AA Schedules TogetherFigure 16-9: How the Economy Reaches Its Short-Run EquilibriumExchangeRate, EDDE2E3E1231AAY1Copyright 2003 Pearson Education, Inc.Output, YSlide 16-35
Temporary Changesin Monetary and Fiscal Policy Two types of government policy: Monetary policy– It works through changes in the money supply. Fiscal policy– It works through changes in government spending ortaxes. Temporary policy shifts are those that the publicexpects to be reversed in the near future and do notaffect the long-run expected exchange rate. Assume that policy shifts do not influence the foreigninterest rate and the foreign price level.Copyright 2003 Pearson Education, Inc.Slide 16-36
Temporary Changesin Monetary and Fiscal Policy Monetary Policy An increase in money supply (i.e., expansionarymonetary policy) raises the economy’s output.– The increase in money supply creates an excess supplyof money, which lowers the home interest rate.– As a result, the domestic currency must depreciate (i.e., homeproducts become cheaper relative to foreign products) andaggregate demand increases.Copyright 2003 Pearson Education, Inc.Slide 16-37
Temporary Changesin Monetary and Fiscal PolicyFigure 16-10: Effects of a Temporary Increase in the Money SupplyExchangeRate, EDD2E2E11AA2AA1Y1Copyright 2003 Pearson Education, Inc.Y2Output, YSlide 16-38
Temporary Changesin Monetary and Fiscal Policy Fiscal Policy An increase in government spending, a cut in taxes, orsome combination of the two (i.e, expansionary fiscalpolicy) raises output.– The increase in output raises the transactions demandfor real money holdings, which in turn increases thehome interest rate.– As a result, the domestic currency must appreciate.Copyright 2003 Pearson Education, Inc.Slide 16-39
Temporary Changesin Monetary and Fiscal PolicyFigure 16-11: Effects of a Temporary Fiscal ExpansionExchangeRate, EDD1DD2E112E2AAY1Copyright 2003 Pearson Education, Inc.Y2Output, YSlide 16-40
Temporary Changesin Monetary and Fiscal Policy Policies to Maintain Full Employment Temporary disturbances that lead to recession can beoffset through expansionary monetary or fiscalpolicies.– Temporary disturbances that lead to overemploymentcan be offset through contractionary monetary or fiscalpolicies.Copyright 2003 Pearson Education, Inc.Slide 16-41
Temporary Changesin Monetary and Fiscal PolicyFigure 16-12: Maintaining Full Employment After a Temporary Fall inWorld Demand for Domestic ProductsExchangeRate, EDD2DD1E3E2321E1AA2AA1Copyright 2003 Pearson Education, Inc.Y2YfOutput, YSlide 16-42
Temporary Changesin Monetary and Fiscal PolicyFigure 16-13: Policies to Maintain Full Employment Aftera Money-Demand IncreaseExchangeRate, EDD1DD2E1E2123E3AA1AA2Y2Copyright 2003 Pearson Education, Inc.YfOutput, YSlide 16-43
Inflation Bias and OtherProblems of Policy Formulation Problems of policy formulation: Inflation bias– High inflation with no average gain in output thatresults from governments’ policies to prevent recession Identifying the sources of economic changesIdentifying the durations of economic changesThe impact of fiscal policy on the government budgetTime lags in implementing policiesCopyright 2003 Pearson Education, Inc.Slide 16-44
Permanent Shifts inMonetary and Fiscal Policy A permanent policy shift affects not only the currentvalue of the government’s policy instrument but alsothe long-run exchange rate. This affects expectations about future exchange rates. A Permanent Increase in the Money Supply A permanent increase in the money supply causes theexpected future exchange rate to rise proportionally.– As a result, the upward shift in the AA schedule isgreater than that caused by an equal, but transitory,increase (compare point 2 with point 3 in Figure 16-14).Copyright 2003 Pearson Education, Inc.Slide 16-45
Permanent Shifts inMonetary and Fiscal PolicyFigure 16-14: Short-Run Effects of a Permanent Increase in the MoneySupplyExchangeRate, EDD12E231E1AA2AA1Copyright 2003 Pearson Education, Inc.YfY2Output, YSlide 16-46
Permanent Shifts inMonetary and Fiscal Policy Adjustment to a Permanent Increase in the MoneySupply The permanent increase in the money supply raisesoutput above its full-employment level.– As a result, the price level increases to bring theeconomy back to full employment. Figure 16-15 shows the adjustment back to fullemployment.Copyright 2003 Pearson Education, Inc.Slide 16-47
Permanent Shifts inMonetary and Fiscal PolicyFigure 16-15: Long-Run Adjustment to a Permanent Increase in theMoney SupplyExchangeRate, EDD2DD12E2E3E13AA21AA3AA1Copyright 2003 Pearson Education, Inc.YfY2Output, YSlide 16-48
Permanent Shifts inMonetary and Fiscal Policy A Permanent Fiscal Expansion A permanent fiscal expansion changes the long-runexpected exchange rate.– If the economy starts at long-run equilibrium, apermanent change in fiscal policy has no effect onoutput.– It causes an immediate and permanent exchange rate jump thatoffsets exactly the fiscal policy’s direct effect on aggregatedemand.Copyright 2003 Pearson Education, Inc.Slide 16-49
Permanent Shifts inMonetary and Fiscal PolicyFigure 16-16: Effects of a Permanent Fiscal Expansion Changingthe Capital StockExchangeRate, EDD1DD2E1132E2AA1AA2YfCopyright 2003 Pearson Education, Inc.Output, YSlide 16-50
Macroeconomic Policiesand the Current Account XX schedule It shows combinations of the exchange rate and outputat which the CA balance would be equal to somedesired level. It slopes upward because a rise in output encouragesspending on imports and thus worsens the currentaccount (if it is not accompanied by a currencydepreciation). It is flatter than DD.Copyright 2003 Pearson Education, Inc.Slide 16-51
Macroeconomic Policiesand the Current Account Monetary expansion causes the CA balance to increasein the short run (point 2 in Figure 16-17). Expansionary fiscal policy reduces the CA balance.– If it is temporary, the DD schedule shifts to the right(point 3 in Figure 16-17).– If it is permanent, both AA and DD schedules shift(point 4 in Figure 16-17).Copyright 2003 Pearson Education, Inc.Slide 16-52
Macroeconomic Policiesand the Current AccountFigure 16-17: How Macroeconomic Policies Affect the Current AccountExchangeRate, EDDXX2E1134YfCopyright 2003 Pearson Education, Inc.AAOutput, YSlide 16-53
Gradual Trade Flow Adjustmentand Current Account Dynamics The J-Curve If imports and exports adjust gradually to realexchange rate changes, the CA may follow a J-curvepattern after a real currency depreciation, firstworsening and then improving.– Currency depreciation may have a contractionary initialeffect on output, and exchange rate overshooting will beamplified. It describes the time lag with which a real currencydepreciation improves the CA.Copyright 2003 Pearson Education, Inc.Slide 16-54
Gradual Trade Flow Adjustmentand Current Account DynamicsCurrent account (indomestic output units)Figure 16-18: The J-CurveLong-runeffect of realdepreciationon the currentaccount132TimeReal depreciation takesplace and J-curve beginsCopyright 2003 Pearson Education, Inc.End of J-curveSlide 16-55
Gradual Trade Flow Adjustmentand Current Account Dynamics Exchange Rate Pass-Through and Inflation The CA in the DD-AA model has assumed thatnominal exchange rate changes cause proportionalchanges in the real exchange rates in the short run. Degree of Pass-through– It is the percentage by which import prices rise when thehome currency depreciates by 1%.– In the DD-AA model, the degree of pass-through is 1.– Exchange rate pass-through can be incomplete becauseof international market segmentation.– Currency movements have less-than-proportional effects onthe relative prices determining trade volumes.Copyright 2003 Pearson Education, Inc.Slide 16-56
Summary The aggregate demand for an open economy’s output consists of four components: consumption demand,investment demand, government demand, and thecurrent account.Output is determined in the short run by the equalityof aggregate d
Asset Market Equilibrium in the Short Run: The AA Schedule Output, the Exchange Rate, and Asset Market Equilibrium We will combine the interest parity condition with the money market to derive the asset market equilibrium in the short-run. The interest parity condition describing foreign exchange ma
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Part One: Heir of Ash Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 Chapter 20 Chapter 21 Chapter 22 Chapter 23 Chapter 24 Chapter 25 Chapter 26 Chapter 27 Chapter 28 Chapter 29 Chapter 30 .
TO KILL A MOCKINGBIRD. Contents Dedication Epigraph Part One Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Part Two Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18. Chapter 19 Chapter 20 Chapter 21 Chapter 22 Chapter 23 Chapter 24 Chapter 25 Chapter 26
