Output and the Exchange Rate in the Short Run

1
Chapter 16

• Output and the Exchange Rate in the Short Run

2
Preview

• Determinants of aggregate demand in the short run
• A short run model of output market equilibrium
• A short run model of asset market equilibrium
• A short run model for both output market
  equilibrium and asset market equilibrium
• Effects of temporary and permanent changes in
  monetary and fiscal policies.
• Adjustment of the current account over time.

3
Introduction

• LR models are useful when all prices of inputs
  and outputs have time to adjust.
• In the SR, 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 builds on the previous models of
  exchange rates to explain how output is related
  to exchange rates in the short run.
• macroeconomic policies affect output, employment
  and the current account.

4
Determinants of Aggregate Demand (AD)

• AD aggregate amount of goods and services that
  people are willing to buy
• consumption expenditure C
• investment expenditure I
• government purchases G
• net expenditure by foreigners the current
  account, CA.
• AD CIGCA

5
Determinants of AD

• Determinants of C
• -Disposable income (Yd) income from production
  (Y) minus taxes (T). ? Yd means ? C but ?C lt ?
  Yd.
• Real interest rates may influence the amount of
  saving and C, and wealth may influence C but we
  assume that they are unimportant
• Determinants of CA EX IM
• -Disposable income ? Yd means more expenditure
  on foreign products (imports), IM ? thus CA?.
• -Foreign income ? Y means more expenditure by
  foreigners on our products, EX ? thus CA ?.
• -Real exchange rate prices of foreign products
  relative to the prices of domestic products, both
  measured in domestic currency EP/P
• As the prices of foreign products rise relative
  to those of domestic products, expenditure on
  domestic products rises and expenditure on
  foreign products falls.

6
How Real Exchange Rate Changes Affect CA

• The CA measures the value of exports relative to
  the value of imports CA EX IM.
• When the real exchange rate EP/P (q) rises,
  foreign products become expensive relative to
  domestic products.
• The volume of exports bought by foreigners ? ?CA
• The volume of imports bought by domestic
  residents? ?CA
• The value of imports in terms of domestic
  products ? the value/price of imports rises,
  since foreign products are more
  valuable/expensive ?CA
• Evidence indicates that for most countries the
  volume effect dominates the value effect in 1
  year or less. Therefore, we assume that the
  volume effect dominates the value effect
• A real depreciation (? q) leads to a ?CA surplus.

7
Determinants of AD (cont.)

• We assume that exogenous political factors
  determine government purchases G and the level of
  taxes T.
• For simplicity, we currently assume that
  investment expenditure I is determined
  exogenously.
• A more complicated model shows that investment
  depends on the cost of borrowing for investment,
  the interest rate.

8
Determinants of AD (cont.)

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

9
Determinants of AD (cont.)

• Determinants of aggregate demand include
• Real exchange rate (EP/Pq) a ?in q ? CA, and
  therefore ? AD for domestic products.
• Disposable income a ? in Yd ?C, but ? CA.
• Since total C expenditure is gt expenditure on
  foreign products, the 1st effect dominates the
  2nd effect.
• As Y ? for a given level of taxes, C and AD ? lt
  ? Y

10
SR Equilibrium for AD and Output Y

• Equilibrium is achieved when the value of output
  Y (and income from production) AD.
• Y D( EP/P, YT, I, G, Y )
• 
  

Note despite its similarity with the national
income identity, this is not an accounting
identity it is an equilibrium condition. The
equilibrium is where the LHS and RHS, plotted as
functions of Y, intersect.
11
Figure 16-2 The Determination of Output in the
Short Run
ADltY, Firms decrease output
ADgtY, firms Increase output
12
Output Market Equilibrium

• The previous analysis determines Y given EP/P.
  We now determine Y and EP/P jointly in the SR,
  in the output and the asset markets.
• Note With fixed prices, changes in EP/P
  changes in E.
• The DD schedule shows combinations of Y and E for
  which the output market is in SR equilibrium (AD
  Y).
• A rise in EP/P (due to a rise in E, P or fall
  in P) makes foreign output more expensive than
  domestic output. This increases AD (shifts the
  AD schedule up). In equilibrium, Y matches AD,
  hence Y increases (vice versa for a fall in
  EP/P).
• Hence, the DD schedule slopes upward

13
Figure 16-4 The DD Schedule
14
Factors that shift the DD curve

• Changes in the exchange rate cause movements
  along a DD curve. Factors other than E causing an
  increase in AD, shift the AD schedule up and the
  DD schedule to the right
• for ex ? G ? ? AD and Y in equilibrium. Y ? for
  every E DD curve shifts right.
• Higher government expenditure G
• Lower taxes T
• Higher investment I
• A fall in domestic prices P
• A rise in foreign prices P
• Higher domestic consumption due to change in
  tastes
• Structural demand shifts from foreign to domestic
  goods

15
Figure 16-5 Government Demand and the DD Schedule
A rise in G to G2 raises Y at every Level of E.
Thus DD shifts to right
16
SR Equilibrium for Assets

• Asset market equilibriumequilibrium in both FX
  market and M market.
• FX market interest parity determines
  equilibrium. R R (Ee E)/E
• Money market real money supply and demand
  determine equilibrium. Ms/P L(R, Y)
• When ?Y ? ? L (real money demand)
• leading to a ? in R, leading to ? E, appreciation
  of the domestic currency.
• When ? Y, E ?, the domestic currency depreciates.
• A market equilibrium (AA) an inverse
  relation between Y and E, AA slopes downward

17
Figure 16-6 Output and the Exchange Rate in
Asset Market Equilibrium
E1
1'
Domestic-currency return on foreign- currency
deposits
R1
L(R, Y1)
L(R, Y2)
2
18
Figure 16-6 Output and the Exchange Rate in
Asset Market Equilibrium
E1
1'
Domestic-currency return on foreign- currency
deposits
R1
L(R, Y)
2
19
Figure 16-7 The AA Schedule
E1,Y1equilibrium Y in M market and
Equilibrium E in FX market
AA negatively sloped because equilibrium in A
markets lead to a negative relation between Y and
E ?Y ? XD for M??R and ?E
20
Shifting the AA Curve
E
? MS ??R then ? E for every Y or ? Y for every
E ?AA shifts up (right).
XS of M reduces R. US assets become less
attractive, investors switch to foreign assets,
sell , the US depreciates for given Y
21
Shifting the AA Curve

• Factors other than the exchange rate causing a
  fall in real money demand, rise in MS, or a rise
  in foreign currency returns, shift the AA
  schedule to the right
• ? in domestic prices P An decrease in P
  increases M/P, decreases R, causing the to
  depreciate (a rise in E) the AA curve shifts up
  (right).
• ? Ee if markets expect the to depreciate in
  the future, foreign assets become more
  attractive, causing the US to depreciate (a rise
  in E) the AA curve shifts up (right).
• ? in R foreign assets become more attractive,
  leading to a depreciation of the US (a rise in
  E) the AA curve shifts up (right).
• A structural ? in real money demand or a rise in
  real MS if domestic residents are willing to
  hold lower real money balances, R falls, leading
  to a depreciation of the US (a rise in E) the
  AA curve shifts up (right).

22
Putting the DD and AA Curves Together

• A short run equilibrium means the nominal
  exchange rate E and level of output Y such that
• equilibrium in the output markets holds ADAS.
• equilibrium in the FX markets holds (UIRP)
  RRx.
• equilibrium in the M market holds M/PL(.)
  Real money supplyReal money demand.
• A short run equilibrium occurs at the
  intersection of the DD and AA curves
• output market equilibrium holds on the DD curve
• asset market equilibrium holds on the AA curve

23
Figure 16-8 Short-Run Equilibrium of Output and
Asset Market the intersection of the DD
and AA curves
24
Figure 16-9 How the Economy Reaches Its
Short-Run Equilibrium
E adjusts immediately so that asset markets are
in equilibrium.
The US appreciates and Y increases until output
markets are in equilibrium
25
Temporary Changes in Monetary Policy (MP) and
Fiscal Policy (FP)

• MP policy in which the central bank (CB)
  influences the MS MP primarily influences asset
  markets (Money market and FX market).
• FP policy in which governments (fiscal
  authorities) influence the amount of government
  purchases G and taxes T. FP primarily influences
  AD and Y.
• Temporary policy changes are expected to be
  reversed in the near future and thus do not
  affect Ee, expectations about exchange rates in
  the long run. We also assume policy changes not
  to affect R and P(a reasonable assumption for a
  small economy less realistic for a large
  economy.)

26

• Temporary Changes in Monetary Policy
• A change in monetary policy shifts the AA curve
  but leaves the DD curve unchanged.
• An increase in MS (i.e., expansionary MP) creates
  an XS of M which lowers R.
• As a result, E depreciates (i.e., home products
  become cheaper relative to foreign products) and
  AD increases.
• A temporary expansionary MP increases Y and
  depreciates E .

27
Figure 16-10 Effects of a Temporary Increase in
the Money Supply
28

• Temporary Changes in Fiscal Policy
• A change in FP shifts the DD curve but leaves the
  AA curve unchanged.
• An increase in G, a cut in T, or a combination of
  the two (i.e., expansionary FP) shifts DD to
  right, increases Y, raises the transactions
  demand for real money balances (MD), which in
  turn increases R.
• As a result, E appreciates.
• A temporary expansionary FP increases Y and
  appreciates the currency.

29
Figure 16-11 Effects of a Temporary Fiscal
Expansion
30
Government policies may help maintain full
employment

• Resources used in the production process can
  either be over-employed or under-employed. When
  resources are employed at their normal (or long
  run) level, the economy operates at full
  employment YF.
• If YltYF, few hours worked, lower than normal
  output produced resulting in high unemployment.
• If YgtYF employment is above full employment, many
  overtime hours, higher than normal output
  produced resulting in inflationary pressures.

31

• Government policies may help maintain full
  employment
• Temporary disturbances leading to recessions can
  be offset through expansionary MP or FP.
• Temporary disturbances leading to overemployment
  can be offset through contractionary MP or FP.
• However, we must use policies that correct for
  the right shock
• In response to lower demand for domestic Y (e.g.,
  a fall in world demand), FP must expand
  expansionary MP would further weaken E.
• In response to higher demand for domestic
  currency (e.g., from foreign investors), MP must
  expand expansionary FP would further strengthen
  E.

32
Figure 16-12 Maintaining full Employment After a
Temporary Fall in Demand for Domestic Products
A fall in world demand for our output shifts DD
to DD2, Y falls to Y2 below Yf, E depreciates to
E2.
Temporary fiscal expansion restores eqm back to
1, no Change in E
Temporary monetary expansion restores Y back to
Yf but causes further E depreciation.
33
Figure 16-13 Maintaining Full Employment After
a Temporary Increase
in Money Demand
A rise in money demand shifts AA to AA2, Y falls
to Y2 below Yf, E appreciates to E2.
Temporary monetary expansion restores eqm back
to 1, no change in E.
Temporary fiscal expansion restores eqm back to
1, but E appreciates further.
34

• Problems in policy implementation
• Inflation bias Government may try to take
  advantage of sticky prices by pursuing
  expansionary monetary policy. But if the public
  anticipates this strategy, it will bargain for
  higher wages, causing higher prices and no output
  gain.
• It may be difficult to trace the source of shocks
  to either output or asset markets.
• Fiscal policy has an impact on the government
  budget it may have to be reverted in the
  future, or it may be offset by changes in private
  savings (Ricardian equivalence).
• Time lags in implementing policies fiscal
  policy changes are often slow to be agreed upon
  monetary policy changes have often effect with
  long lags.

35
Short Run Effects of Permanent Shifts in Monetary
and Fiscal Policy

• Permanent policy shifts affect the long-run E
  and, therefore, the future expected exchange
  rate, Ee.
• Permanent Monetary Expansion (increase in money
  supply) has the following SR effects
• lowers R and makes people expect a future
  depreciation of the domestic currency, increasing
  the expected return of foreign currency deposits.
  
• E and Y rise more than the case when expectations
  are constant (Chapter 14 results).
• The AA curve right (point 3) more than the case
  when expectations are held constant (point 2).

36
Figure 16-14 Short-Run Effects of a Permanent
Increase in Money Supply
37
Long-Run Effects of Permanent Changes in Monetary
Policy

• With employment and hours above their normal
  levels, there is a tendency for wages to rise
  over time.
• With strong demand for Y and with increasing
  wages, producers have an incentive to raise
  output prices over time.
• Both higher wages and higher output prices are
  reflected in a higher price level.
• What are the effects of rising prices?

38
Figure 16-15 Long-Run Adjustment to a
Permanent Increase in Money Supply
As P rises, 1. EP/P falls (real appreciation),
loss of Competitiveness, CA deteriorates,
AD falls and DD shifts to left. 2. M/P falls, AA
shifts to left. As R rises, E appreciates also.
If the horizontal shift of AA is larger than that
of DD, we observe overshooting of E by E2-E4.
Otherwise, Undershooting occurs. Y goes back to
Yf
39
Effects of Permanent Changes in Fiscal Policy

• A permanent increase in G or reduction in T
• Effect on goods market AD rises, DD shifts to
  right.
• Effect on asset market people expect a domestic
  currency appreciation in the short run due to
  increased AD, Ee falls, thereby reducing the
  expected return on foreign currency deposits, AA
  shifts to left
• The second shift offsets the first shift the
  shift in exchange rate expectation limits the
  expansionary effect of FP it crowds out AD
  for domestic products, by making them more
  expensive internationally.
• When the economy starts at full employment, the
  offset is complete permanent fiscal expansions
  have no effect on output.

40
Figure 16-16 Effects of a Permanent Fiscal
Expansion
2 Temporary fiscal expansion
3 new equilibrium with permanent fiscal
expansion. If we start at Yf, the effect of
permanent fiscal expansion is zero.
41
Macroeconomic Policies and the Current Account

• We study the current account effect of policies
  by including in the DD-AA model a schedule XX
  showing combinations of E and Y at which CA
  equals its desired level X
• CA( EP/P, Y-T ) X
• X may be zero or less than zero, for a
  developing economy that needs foreign capital to
  finance growth or greater than zero, for a
  mature economy repaying foreign debt.
• The schedule XX slopes upward (?E/?Ygt0) because a
  rise in Y raises imports and thereby worsens the
  CA thus E must rise to restore equilibrium.

42

• The XX schedule is flatter than the DD schedule
• XX schedule as Y rises CA goes into deficit and
  hence E must rise to bring it back to its desired
  level (X).
• DD schedule as Y rises CA goes into deficit and
  AD falls. But a rise in Y also creates excess
  supply in goods market (saving). Thus, in order
  to equate AD to Y, E must rise not only to clear
  the CA component of AD but also to remove the
  excess supply by increasing foreigners demand
  for our product and thus AD further.
• Hence when Y rises, the rise in E is higher for
  DD than for XX. ?E/?Yslope XX lt ?E/?Yslope DD.
• Note CA need not be 0 at the short run
  equilibrium. For simplicity, however, we suppose
  that it is.

43
Equilibrium and the Current Account
On any point above XX, CA is in surplus For
given Y, a rise in E leads to CA
XX
On any point below XX, CA is in deficit for
given E, a rise in Y leads to a CA-
44
Macroeconomic Policies and the CA

• Policies affect the CA through their influence on
  the value of the domestic currency.
• A monetary expansion depreciates the domestic
  currency and often increases the CA in the short
  run (point 2 in Figure 16-17).
• A fiscal expansion (increase in government
  purchases or decrease in taxes) appreciates the
  currency and worsens the CA
• A temporary expansion shifts the DD schedule to
  the right (point 3 in Figure 16-17).
• A permanent expansion shifts both the AA and the
  DD schedules (point 4 in Figure 16-17).

45
Figure 16-17 Macroeconomic Policies and the
Current Account
2 CA Temporary expansion in monetary policy.
XX
3 CA- Temporary expansion in fiscal policy
4 CA- Permanent expansion in fiscal policy
46
Gradual Trade Adjustment, the CA and the J-Curve

• The DD-AA model assumes real depreciations (rise
  in EP/P) to improve the CA immediately (vice
  versa for appreciations).
• However, the volume of imports and exports
  responds slowly to a change in the real exchange
  rate. But the value of imports become immediately
  more expensive. A depreciation may then have an
  initial negative effect on the CA.
• Thus the CA may follow a J-curve pattern after a
  real currency depreciation
• First the CA worsens, as the price of import
  rises and export and import volumes have not yet
  responded.
• Next, the CA begins to improve, as the volume of
  export rises and the volume of import falls.
• Empirical evidence is for most industrial
  countries CA to start improving beginning about
  a year after a devaluation.

47
Figure 16-18 The J-Curve
Volume effect dominates the value effect
Value effect dominates the volume effect.
48
Pass Through Effect

• Pass through from the exchange rate to import
  prices measures the percentage by which dollar
  import prices rise when the dollar depreciates by
  1.
• If PmE.Pm (where Pmdollar price of imports,
  Pmforeign price of imports) then pass through
  shows by how much Pm rises when E rises by 1.
• In the DD-AA model, the pass through rate is
  100 import prices in domestic currency exactly
  match a depreciation of the domestic currency
  ?Pm/?E1
• In reality, pass through may be less than 100
  due to price discrimination in different
  countries.
• firms that set prices may decide not to match
  changes in the exchange rate with changes in
  prices of foreign products denominated in
  domestic currency.

49
Pass Through and the J-curve

• If prices of foreign products in domestic
  currency do not change much because of a pass
  through rate less than 100, then the
• value of imports will not rise much after a
  domestic currency depreciation, and the current
  account will not fall much, making the J-curve
  effect smaller.
• volume of imports and exports will not adjust
  much over time since domestic currency prices do
  not change much.
• Pass through less than 100 dampens the effect of
  depreciation or appreciation on the current
  account.