Output and the Exchange Rate in the Short Run

1
Output and the Exchange Rate in the Short Run

• Chapter 17 Krugman and Obstfeld 9e
• ECO41 International Economics
• Udayan Roy

2
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 short run
  behavior of a small economy with flexible
  exchange rates under perfect capital mobility

3
The DD curve
4
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
• consumption expenditure (C)
• investment expenditure (I)
• government purchases (G)
• net expenditure by foreigners the current
  account (CA)

5
Determinants of Aggregate Demand

• Consumption expenditure (C) depends on Disposable
  Income (Y-T), which is income (Y) minus taxes
  (T).
• More disposable income means more consumption
  expenditure
• But consumption typically increases less than the
  amount by which disposable income increases.
• 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.

6
Determinants of Aggregate Demand

• The current account (CA) depends on
• Real exchange rate (q), which is the price of
  foreign products relative to the price of
  domestic products q EP/P
• As q rises, expenditure on domestic products
  rises and expenditure on foreign products falls.
  Therefore, when q rises, CA rises as well.
• Disposable income more disposable income (Y-T)
  means more expenditure on foreign products
  (imports). Therefore, when Y-T rises, CA falls.

7
Determinants of Aggregate Demand

• Determinants of the current account include
• Real exchange rate an increase in the real
  exchange rate increases the current account.
• Disposable income an increase in the disposable
  income decreases the current account.

8
Determinants of Aggregate Demand (cont.)

• For simplicity, we assume that exogenous
  political factors determine government purchases
  (G) and the level of taxes (T).
• For simplicity, we assume that investment
  expenditure (I) is also determined exogenously by
  business sentiment.
• A more complex model might assume that investment
  depends on the cost of borrowing for investment,
  the interest rate.

9
Determinants of Aggregate Demand (cont.)

• Aggregate demand is therefore expressed as
• D C(Y T) I G CA(EP/P, Y T)
• Or more simply
• D D(EP/P, Y T, I, G)

10
Determinants of Aggregate Demand (cont.)

• Determinants of aggregate demand include
• Real exchange rate an increase in the real
  exchange rate increases the current account, and
  therefore increases aggregate demand for domestic
  products.
• Disposable income an increase in the disposable
  income increases consumption, but decreases the
  current account.
• Since total consumption expenditure is usually
  greater than expenditure on foreign products, the
  first effect dominates the second effect.
  Therefore,
• When disposable income increases, aggregate
  demand increases, but by less than the increase
  in disposable income.
• Therefore, when income increases or taxes
  decrease (or both), aggregate demand increases.

11
Determinants of Aggregate Demand (cont.)

• Determinants of aggregate demand include
• Government Spending an increase in government
  spending (G) increases aggregate demand for
  domestic products (D).
• Business Investment an increase in business
  investment (I) increases aggregate demand (D).

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Short Run Equilibrium for Aggregate Demand and
Output

• Equilibrium is achieved when the value of output
  Y equals aggregate demand D.
• Y D(EP/P, Y T, I, G)

13
Fig. 17-2 The Determination of Output in the
Short Run
Output is greater than aggregate demand
firms decrease output
Aggregate demand is greater than production
firms increase output
14
Short Run Equilibrium and the Exchange Rate DD
Schedule

• How does the value of the foreign currency (E)
  affect the short run equilibrium of aggregate
  demand and output?
• Domestic and foreign price levels (P and P) are
  assumed fixed in the short run.
• Therefore, a rise in the nominal exchange rate
  (E) makes foreign goods more expensive relative
  to domestic goods. That is, q E P/P
  increases when E increases.
• As a result, CA increases and, therefore, D
  increases. That is, D increases when E increases.
  See Fig 17-3.
• In equilibrium, Y D. Therefore, Y increases
  when E increases.
• This gives the DD curve. See Fig 17-4.

Y D(EP/P, Y T, I, G)
15
Fig. 17-3 Output Effect of a Currency
Depreciation with Fixed Output Prices
Y D(EP/P, Y T, I, G)
16
Fig. 17-4 Deriving the DD Schedule
Y D(EP/P, Y T, I, G)
17
Shifting the DD Curve

• Changes in the exchange rate cause movements
  along a DD curve. Other changes may cause it to
  shift
• Changes in G more government purchases cause
  higher aggregate demand and output in
  equilibrium. Output increases for every exchange
  rate the DD curve shifts right.

18
Fig. 17-5 Government Demand and the Position of
the DD Schedule
An increase in G causes the DD curve to shift to
the right.

• The same rightward shift of the DD curve happens
  if
• I increases
• T decreases
• P/P increases

Y D(EP/P, Y T, I, G)
19
Shifting the DD Curve

• The DD curve shifts right if
• G increases
• T decreases
• I increases
• P decreases
• P increases
• C increases for some unknown reason
• CA increases for some unknown reason

Y D(EP/P, Y T, I, G)
20
The aa curve
21
Short Run Equilibrium for Assets

• We consider two asset markets when considering
  asset market equilibrium
• Ch 14 Foreign exchange market
• interest parity R R (Ee E)/E
• Ch 15 Money market
• real money supply and demand determine
  equilibrium Ms/P L(R, Y)

22
What makes the value of the euro (E) change?
Note the inverse relation between Y and E. This
yields another curve linking Y and E the AA
curve.
M/P
(-)
()
R
Y
(-)
Domestic preference for cash
()
E
()
(-)
M/P
R
()
Y
()
Ee
()
Foreign preference for cash
23
Fig. 17-7 The AA Schedule
24
Recap What makes (E), the value of the foreign
currency, change?
Note the inverse relation between Y and E. This
yields another curve linking Y and E the AA
curve.
M/P
(-)
()
R
Y
But E is also affected by changes in M/P, Ee, and
L, the preference for cash.
(-)
Domestic preference for cash
()
E
()
(-)
M/P
R
()
Y
()
Ee
()
Foreign preference for cash
25
Shifting the AA Curve

• The AA curve shifts right if
• Ms increases
• P decreases
• Ee rises
• R rises
• L decreases for some unknown reason

E
E0
E1
Y
Y0
Y1
26
Short-run macroeconomic equilibrium
27
Putting the Pieces Together the DD and AA Curves

• A short run equilibrium means that the exchange
  rate (E) and output (Y) are such that there is
  equilibrium in
• the output market aggregate demand (D) equals
  aggregate output (Y).
• the foreign exchange market interest parity
  holds.
• the money market real money supply (MS/P) equals
  real money demand (L).

Y D(EP/P, Y T, I, G)
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Fig. 17-8 Short-Run Equilibrium The
Intersection of DD and AA
The short run equilibrium occurs at the
intersection of the DD and AA curves
The output market is in equilibrium on the DD
curve
The asset markets are in equilibrium on the DD
curve
29
Shifting the AA and DD Curves

• The AA curve shifts right if
• Ms increases
• P decreases
• Ee rises
• R rises
• L decreases for some unknown reason

• The DD curve shifts right if
• G increases
• T decreases
• I increases
• P decreases
• P increases
• C increases for some unknown reason
• CA increases for some unknown reason

30
Short-run effects of temporary changes in
government policy
31
Temporary Changes in Monetary and Fiscal Policy

• Monetary policy policy in which the central bank
  influences the money supply (MS).
• Monetary policy primarily influences asset
  markets.
• Fiscal policy policy in which governments
  influence the amount of government purchases (G)
  and taxes (T).
• Fiscal policy primarily influences aggregate
  demand (D).
• Temporary policy changes are expected to be
  reversed in the near future and thus do not
  affect expectations about exchange rates in the
  long run. Specifically, temporary changes in MS,
  G, and T do not affect Ee.

32
Shifting the AA and DD Curves

• The AA curve shifts right if
• Ms increases
• P decreases
• Ee rises
• R rises
• L decreases for some unknown reason

• The DD curve shifts right if
• G increases
• T decreases
• I increases
• P decreases
• P increases
• C increases for some unknown reason
• CA increases for some unknown reason

33
Temporary Changes in Monetary Policy

• When there is an increase in the supply of money
• The AA shifts up (right).
• Both E and Y increase
• R decreases
• As Ee is unaffected when the change in Ms is
  temporary, the increase in E leads to a decrease
  in R recall R R (Ee E)/E.

E
DD
E0
Y
Y0
34
Fig. 17-10 Effects of a Temporary Increase in
the Money Supply
R? and Ee ? have the same effect, as does a fall
in money demand (L).
35
Effect of temporary MS? on CA

• Goods market equilibrium (DD curve) Y C(Y
  T) I G CA.
• An increase in Ms causes Y to increase. But C(Y
  T) increases less than Y does. Therefore, CA must
  increase.
• That is, an increase in the supply of money,
  leads to an increase in the current account
  balance (or, net exports)

36
Temporary Changes in Fiscal Policy

• An increase in government purchases or a decrease
  in taxes increases aggregate demand and output.
• The DD curve shifts right.
• Higher output increases real money demand, and
• thereby increases interest rates,
• causing an increase in the value of the domestic
  currency (a fall in E).

37
Shifting the AA and DD Curves

• The AA curve shifts right if
• Ms increases
• P decreases
• Ee rises
• R rises
• L decreases for some unknown reason

• The DD curve shifts right if
• G increases
• T decreases
• I increases
• P decreases
• P increases
• C increases for some unknown reason
• CA increases for some unknown reason

38
Fig. 17-11 Effects of a Temporary Fiscal
Expansion G ? and/or T ?
P? and I? have the same effect, as do shocks
that increase C and CA. E? implies R? because R
R Ee/E - 1.
39
Effect of G? and/or T? on CA

• When G? and/or T? this is called expansionary
  fiscal policy E? and Y?.
• Therefore, CA?.
• Expansionary (contractionary) fiscal policy
  reduces (increases) net exports.

40
Fig. 17-12 Maintaining Full Employment After a
Temporary Fall in World Demand for Domestic
Products
Temporary fall in world demand for domestic
products reduces output below its normal level
Temporary monetary expansion could depreciate
the domestic currency
Temporary fiscal policy could reverse the fall
in aggregate demand and output
41
Fig. 17-13 Policies to Maintain Full Employment
After a Money Demand Increase
Temporary monetary policy could increase money
supply to match money demand
Increase in money demand raises interest rates
and appreciates the domestic currency
Temporary fiscal policy could increase aggregate
demand and output
42
Short-run effects of permanent changes in
government policy
43
Permanent Changes in Monetary and Fiscal Policy

• Permanent policy changes modify peoples
  expectations about future exchange rates (Ee)
• when they change the long-run value of Ef.

44
Permanent Increase in Money Supply

• The AA curve shifts right because of the increase
  in MS. The equilibrium moves from point 1 to
  point 3 in Fig 17-14.
• In the long run, E will rise. See Table 16-1.
• This will have the immediate effect of raising
  Ee.
• The increase in Ee shifts the AA curve to the
  right again.
• The equilibrium moves from point 3 to point 2 in
  Fig 17-14.
• Both E and Y increase more for a permanent
  increase in MS than for a temporary increase in
  MS.

45
Fig. 17-14 Short-Run Effects of a Permanent
Increase in the Money Supply
46
Table 16-1 Effects of Money Market and Output
Market Changes on the Long-Run Nominal
Dollar/Euro Exchange Rate, E/
47
Permanent ? in Ms Overshooting?
AA1 is the initial AA curveAA2 is AA1 plus
effect of Ee? caused by permanent ? in Ms.AA3 is
AA2 plus effect of Ms/P? caused by permanent ? in
Ms.In the long run, Ms/P returns to original
level. So, the economy goes from a green dot to a
black dot in the short run, and to the higher of
the two green dots in the long run.
E
E
E
DD2
DD2
DD2
DD1
DD1
DD1
AA3
AA3
AA3
AA2
AA2
AA2
AA1
AA1
AA1
Y
Yf
Y
Yf
Y
Yf
Neither over nor under!
Overshooting
Undershooting
48
Macroeconomic Policies and the Current Account

• By recalling the effects of various policies on
  the real dollar/euro exchange rate (q EP/P)
  and on disposable income (Yd Y - T), we can
  figure out their effects on the current account
  (CA).