In this segment well discuss

1
In this segment well discuss

• 1. Adjustments to a short-run equilibrium.
• 2. AA-DD shifters... the case of a tariff.
• 3. Two Example Problems.
• 4. The real exchange rate and the current acct.
• Two Anomalies - Oil and the J-Curve.

2
ADJUSTMENTS TO A SHORT-RUN EQUILIBRIUM

• Suppose we picked an out-of-equilibrium point
  like pt. A

3
How does the market get from pt. A to the
short-run equilibrium pt?

• We'll assume the following adjustment process
• -- Asset Markets Clear First (Move to a very
  short-run equilibrium).
• -- Goods Market Clears (Asset Market clears the
  whole time).

4
(No Transcript)
5
Economic Story

• We start at Pt. A, which is one neither the AA
  Curve nor the DD Curve. The first step
• -- Allow the asset markets to clear, holding
  income/output at YA.
• -- Pt. A to Pt. B To get the asset markets
  to clear, the exchange rate must fall, from EA to
  EB . Initially, the rate of return on foreign
  assets, when converted to home currency terms,
  must be less than the return on home assets
• (1 R) Ee/EA lt 1 R

6
(No Transcript)
7

• For our original out-of-equilibrium' Pt. A, the
  return is too low.
• (How do we know? ... Cheat. Look at which
  direction the exchange rate must move in order to
  restore interest parity).

8

• Once we are at Pt. B, interest parity hold, but
  the goods market is still out-of-equilibrium. At
  Pt. B, the exchange rate is too low to sustain a
  level of output . The low exchange rate means q,
  the value of foreign goods in terms of home
  goods, is too low, and that at Pt. B, we have a
  low current account and unplanned positive
  investment (we're accumulating inventories).
• (How do we know? ... Cheat again. Look at the
  direction output must move in order to restore
  goods market equilibrium).

9
Agg. Exp. Income/Output
450
AE (Y-T, EBP/P)
YB
Inventories
AEB
YB
Income/Output
10

• This picture tells us that producers will cut
  back production, and incomes and output falls.
• As incomes fall, people make fewer purchases and
  need to hold less cash. They reduce their demand
  for money, but with a given supply of cash, the
  home interest rate must fall in order for the
  home money market to remain in equilibrium.
• As the home interest rate falls, foreign
  exchange traders wish to get out of home assets
  and into foreign assets, and the exchange rate
  rises in the process.

11
(No Transcript)
12

• We see As incomes and output fall, the demand
  for cash falls, home interest rates fall, and the
  exchange rate rises until we arrive at Pt. C.
• In our original picture, this is all shown as a
  movement along the AA curve, from Pt. B to Pt.
  C.

13
At Pt. C, we are in a short-run equilibrium

• The Asset Markets Clear
• Home Money Mkt. Clears
• L (YC RC ) Ms/P
• Interest Parity Holds
• 1 RC ( 1 R )Ee/EC
• The Home Goods Market Clears
• AE(YC - T EC P/P ) YC

14
Shifters of the DD Curve

• Suppose we consider a simple trade policy, such
  as a tariff the Home Country imposes a tariff on
  Foreign Goods.
• What does this do? Normally, we expressed the
  value of Foreign Goods in terms of Home Goods as
• With the tariff...

q E P/P
q (1 Tf)E P/P
15

• Imposing a tariff will reduce the volume of
  imports. The reduction in the volume of imports
  will increase the Home Current Account for each
  exchange rate
• CA(Y -T E P/P) lt CA (Y-T (1 Tf)E P/P )
• This in turn raises aggregate expenditures

16

• Note what this picture suggests
• Initially, when we had an exchange rate of E,
  we had a goods market equilibrium at output Y .
  Now, with the tariff, expenditures on Home
  Product are greater, and this increases the level
  of output corresponding to a goods market
  equilibrium to Y.

17
Our short-run equilibrium is affected in the
following way

18
Example Question 1 (1997)

• For the past 2 months, there has been
  considerable turmoil in a number of Far East
  currency markets, such as Thailand, Malaysia,
  Indonesia, and now Hong Kong. These events have
  resulted in a fairly sharp decline in the value
  of these countries currencies in terms of the
  many major currencies, including the U.S. dollar.
  Also in the news of late have been the following
  headlines (both before and after the crises)
• i) Japanese econ. growth has been weak for
  much of 1997
• ii) Japanese interest rates have been fairly
  low
• iii) There has been some concern over the rising
  U.S. trade deficit with Japan
• iv) There has been some concern over the
  strength of the U.S. dollar relative to the
  Japanese Yen.

19

• Using our AA-DD model and our 2-panel diagram
  (our very short-run model), discuss how the
  currency crisis in these Far East countries may
  impact on the Japanese economy in the short-run.
  Also address the issue of how the crisis will
  impact on the four points i) - iv) listed above.
• HINT 1 To tackle this question, you may want to
  think of things in the following manner. The
  economies of Thailand, Malaysia, Indonesia, and
  Hong Kong compete directly with Japan in many
  export markets around the world. What impact
  will the depreciation of these countries'
  currencies have on Japanese exports world-wide,
  in the short-run? Be specific.
• HINT 2 In drawing your AA-DD picture, assume the
  US is the Foreign Country and Japan is the Home
  Country, with E being the value of the U.S.
  dollar in terms of the yen.

20
Example Question 2 (1997)

• For the last few months, Alan Greenspan has
  taken no specific action regarding a change in
  U.S. monetary policy. Instead, he has shown a
  tendency to "Jawbone" . Mr. Greenspan's concern
  is that the U.S. economy may be growing too fast
  and that this will lead to higher inflation. His
  jawboning is generally viewed by the market as
  veiled comments regarding future monetary policy.
• On Friday, October 10, the headline of an
  article in the New York Times announced,
  "Greenspan's Jawing Gets the Job Done for the
  Fed."

21

• Assume Mr. Greenspan's concern is an
  overheated' U.S. economy - that is, that the US
  economy is operating at a level greater than a
  full employment level of output.
• Discuss how Greenspan's approach of merely
  talking and not acting may actually accomplish
  what he wants to achieve in the short-run, using
  the AA-DD model we developed in class. Be sure
  to explain your answer and why each curve shifts
  the way you claim it shifts.

22
The Real Exchange Rate and The Current Account

• The current account (behavior)
• -
• CA(Y-T E P/P)
• -
• EX(E P/P) - (EP/P) IM (Y -T EP/P)
• In writing the signs above the current account
  in this fashion, we assumed that our imports are
  sufficiently price elastic so that when the real
  exchange rate rises, the current account improves
  instead of worsens.

23
Situations that do not fit the normal pattern

• Oil
• J-Curve
• Whats the deal with oil?
• The demand for oil is typically inelastic in the
  short-run. What happens as the demand for imports
  becomes more price inelastic? Our current account
  becomes less responsive to changes in the
  exchange rate...

24
(No Transcript)
25
The J-Curve

• Look at our expression
• CA(Y-T E P/P) EX(EP/P) - (EP/P) IM(Y -T
  EP/P)
• The immediate impact of a higher exchange rate
  (all else equal) is that we'd pay more for
  imports - in other words, EP/P rises.
• Next, we may export more goods, and import fewer
  goods... in other words, the volume of trade will
  adjust.
• Usually, it takes time for the volume of trade to
  adjust -- we need to find Home substitutes for
  Foreign goods and it takes time for Foreign
  importers to increase orders for Home exports. A
  pattern in trade accounts called the J-Curve
  emerges following a depreciation of your
  currency, the current account initially worsens.

26

• We see the initial impact of a devaluation is a
  worsening, but it improves over time as the
  volume of trade adjusts.

27
AA-DD Model and the J-Curve