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Chapter 16 Output and the Exchange rate in the Short Run ?????????

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Title: Chapter 16 Output and the Exchange rate in the Short Run ?????????


1
Chapter 16 Output and the Exchange rate in
the Short Run ?????????
2
Chapter 16
  • Events
  • In September 1992 Britain allowed the pound
  • sterling to depreciate in the foreign exchange
  • market. The countrys net exports surged as a
  • result, and Britain was lifted out of a recession
  • without a rise in inflation. Six years
    later,countries
  • in East Asia let their currencies depreciate, but
  • they subsequently experienced their most severe
  • postwar recessions along-side higher inflation.

3
Chapter 16
  • QCan the currency depreciation
  • improve the economy recession?

4
Chapter 16
  • The Main Goal
  • This chapter will help us to understand
  • the complicated factors that cause output,
  • exchange rates, and inflation to change
  • by completing the macroeconomic model
  • built in the last two chapters.
  • Our discussion combines what have

5
Chapter 16
  • learned about asset markets and the long
  • -run behavior of exchanges rates with a
  • new element, a theory of how the output
  • market adjusts to demand changes when
  • product prices in the economy are
  • themselves slow to adjust.

6
Chapter 16
  • Chapter Organization
  • 1.Determinants of Aggregate Demand in an
  • Open Economy
  • 2.The Equation of Aggregate Demand
  • 3.Output Market Equilibrium in the Short Run
  • DD Schedule
  • 4.Asset Market Equilibrium in the Short Run
  • AA Schedule
  • 4.Short-run Equilibrium for an Open Economy
  • Putting the DD and AA Schedules Together

7
Chapter 16
  • 5.Temporary Changes in Monetary and Fiscal
  • Policies
  • 6.Inflation Bias and Other Problems of Policy
  • Formulation
  • 7.Permanent Shifts in Monetary and Fiscal
  • Policy
  • 8.Macroeconomic Policies and the Current
  • Account
  • 9.Gradual Trade Flow Adjustment and the
  • Current Account Dynamics

8
Chapter 16
  • Appendix
  • Appendix I The IS-LM Model and the DD-
  • AA Model
  • Appendix II Intertemporal Trade and
  • Consumption Demand
  • Appendix IIIThe Marshell-Lerner Condition
  • and Empirical Estimates
    of
  • Trade Elasticities

9
Chapter 16
  • The Key Points
  • 1.DD schedule(???????)
  • 2.AA schedule(???????)
  • 3.AA-DD model
  • 4.J-curve
  • 5.pass through (??)

10
Chapter 16
  • Determinants of Aggregate Demand in an Open
    Economy
  • 1.Definition
  • Aggregate demand is the amount of a
  • countrys goods and services demanded by
  • households and firms throughout the world.

11
Chapter 16
  • The output market equilibrium is

12
Chapter 16
  • 2.Output in the short run v.s. in the long run
  • In the long run domestic output depends on
  • the available domestic supplies of factors of
  • production.(full employment)
  • In the short run domestic output depends on
  • the aggregate demand for the countrys
  • output.(over-or underemployed)
  • 3.We assume that G , I and Y are both given.

13
Chapter 16
  • 4.Determinants of Consumption Demand
  • (1)disposable income

14
Chapter 16
  • 5.Determinants of the Current Account
  • (1)How Real Exchange Rate Changes
  • Affect the Current Account
  • We assume that a representative domestic
  • expenditure basket includes some imported

15
Chapter 16
  • products but places a relatively heavier
  • weight on goods and services produced
  • domestically. And we also assume that the
  • Marshell-Lerner condition holds.
  • The Marshell-Lerner condition

16
Chapter 16

17
Chapter 16
  • the elasticity of export demand
  • the elasticity of import demand

18
Chapter 16
  • the value effect given
    IM
  • the volume effect
  • the volume effect outweighs the value
  • effect
  • (2)How disposable income changes affect
  • the current account

19
Chapter 16
  • Since a rise in the disposable income
  • causes domestic consumers to increase their
  • spending on all goods, including imports
  • from abroad, an increase in disposable
  • income worsens the current account.

20
Chapter 16
  • The Equation of Aggregate Demand
  • 1.The real exchange rate and aggregate
  • demand
  • q CA D

21
Chapter 16
  • 2.Real income and aggregate demand
  • Y C
  • CA D
  • A representative domestic expenditure
  • basket includes some imported products but
  • places a relatively heavier weight on goods
  • and services produced domestically.
  • 3.Figure 16-1
  • The slope of the DD is less than 1.(MPClt1)

22
Chapter 16
Figure 16-1 Aggregate Demand as a Function of
Output

23
Chapter 16
  • How Output Is Determined in the Short Run
  • 1.We assume that the money prices of
  • goods and services are temporarily fixed.
  • 2.In the long-run equilibrium, factors of
  • production are fully employed, the level

24
Chapter 16
  • of real output is completely determined by
  • factors supplies, and the real exchange rate
  • has adjusted to equate long-run real output to
  • aggregate demand.
  • 3.Figure 16-2
  • (1)The equilibrium is at point 1.
  • (2)point 2 ED for
    domestic
  • output Firms increase their
    production.

25
Chapter 16
  • (3)point 3 ES for domestic
  • output. Firms cut back on
    their
  • production.

26
Chapter 16
Figure 16-2 The Determination of Output in the
Short Run
27
Chapter 16
  • Output Market Equilibrium in the Short Runthe DD
    Schedule
  • 1.the Assumptions are fixed.
  • 2.Output, the Exchange Rate, and Output
  • market Equilibrium
  • Figure 16-3
  • (1)Any rise(fall) in the real exchange rate
    (whether due to a rise(fall) in E, P, or a

28
Chapter 16
Figure 16-3 Output Effect of a Currency
Depreciation with Fixed Output Prices
29
Chapter 16
  • fall(rise) in P) will cause an upward
  • (downward) shift in the aggregate demand
  • function and an expansion(decline) of
  • output, all else equal.
  • (2)Deriving the DD schedule
  • Figure 16-4
  • (3)Factors that shift the DD schedule

30
Chapter 16
Figure 16-4 Deriving the DD Schedule
31
Chapter 16
Figure 16-4 continued...

32
Chapter 16
  • EXa demand shift from foreign to
  • domestic goods
  • EX , IM
  • CA
  • D
  • DD schedule shifts right

33
Chapter 16
Figure 16-5 Government Demand and the Position
of the DD Schedule

34
Chapter 16
Figure 16-5 continued

35
Chapter 16
  • Table 16-1 Factors that shift the DD schedule

Factors D DD schedule shift
G Right
T Yd Left
I Right
P q Left
P q Right
C Right
MPC(d) Right
E or q Right
36
Chapter 16
  • ConclusionAny disturbance that raises
    aggregate demand for domestic output shifts the
    DD schedule to the right any disturbance that
    lowers aggregate demand for domestic output
    shifts the DD schedule to the left.

37
Chapter 16
  • Asset Market Equilibrium in the Short
  • Run The AA Schedule
  • 1.DefinitionThe schedule of exchange rate
  • and output combinations that are consistent
  • with equilibrium in the domestic money
  • market and the foreign exchange market.
  • (1) foreign exchange market equilibrium

38
Chapter 16
  • Uncovered Interest Parity (UIP) R
    R (Ee - E )/E
    (13-2)
  • (2)money market equilibrium
  • Ms / P L ( R,Y )
  • (3)asset market equilibrium(R is given)
  • Figure 16-6
  • For asset markets to remain in
    equilibrium,a
  • rise in domestic output must be accompanied

39
Chapter 16
  • by an appreciation of the domestic
    currency,
  • all else equal, and a fall in domestic
    output
  • must be accompanied by a depreciation.
  • (4)Deriving the AA schedule
  • The AA schedule relates exchange rates
  • and output levels that keep the money and
  • foreign exchange markets in equilibrium.
  • Figure 16-7

40
Chapter 16
Figure 16-6 Output and the Exchange Rate in
Asset Market Equilibrium
41
Chapter 16
Figure 16-7 The AA Schedule
42
Chapter 16
  • 2.Factors that Shift the AA Schedule(Y fixed)
  • Table 16-2 Factors that Shift the AA Schedule

Factors R E AA shift
Ms Right
P Ms/P ,R Left
Ee Right
R Right
L Left
43
Chapter 16
  • Short-Run Equilibrium for an Open
  • EconomyPutting the DD and AA
  • Schedules Together
  • 1.AssumptionR? Ee ?P?P are fixed
  • 2.the short-run equilibriumthe intersection
  • of the DD and AA schedules
  • Figure 16-8point 1 (R1,Y1 )
  • (1) the adjusting process(point 2)

44
Chapter 16
  • at point 2(upper than point 3)
  • E can move immediately when it is away from the
    equilibrium level.
  • E2 is higher than E3 that maintains the
    asset
  • markets equilibrium. E is expected to fall
    in
  • the foreign exchange market. Ee lt E2
  • It implies that the expected return of
    foreign
  • currency is lower than domestic currency.

45
Chapter 16
  • Investors buy domestic currency and
  • sell the foreign one.
  • E (E2 E3 )
  • The E3 is higher than that keeping the
  • output equilibrium. That makes domestic
  • goods are cheaper that the level of
    foreigns,
  • causing an excess demand for domestic
  • goods. The relative price of the U.S. output

46
Chapter 16
  • in terms of European rises.
  • The excess demand for domestic goods
  • makes the aggregate demand of domestic
  • output rise, causing the domestic output
    rises.
  • Y L(R,Y) R
    E

47
Chapter 16
  • Because asset price(E) can jump immediately
  • , the asset markets remain in continual
  • equilibrium while the output market moves
  • gradually from point 3 to point 1.

48
Chapter 16
Figure 16-9 How the Economy Reaches Its
Short-Run Equilibrium
49
Chapter 16
  • Temporary Changes in Monetary and Fiscal Policy
  • 1.AssumptionR? Ee ?P?P are fixed
  • 2.Definition
  • (1)monetary policyworking through changes in
    the money supply(Ms)
  • (2)fiscal policyworking through changes in the
    government spending or taxes(G,T)

50
Chapter 16
  • (3)temporarypolicy shifts that public expects
    to be reversed in the next period
  • ( one-shot, Ee is fixed)
  • 3.Monetary Policy
  • The short-run effect of temporary increase
  • in the domestic money supply
  • (1)The policy does not affect the DD.
  • (2)in the money market

51
Chapter 16
  • Ms
  • there is an excess supply in the money
    market
  • R
  • It implies that the return of domestic
    currency
  • lowers. Investors sell domestic
    currency and
  • buy the foreign one
  • E (in the foreign exchange
    market)

52
Chapter 16
  • (3)in the output market
  • The rising of E makes the relative price
    of domestic goods rise.
  • the relative demand for domestic goods rises
  • Y
  • the short-run effectE , Y
  • (Figure 16-10) (E1,Y1 ) (E2,Y2 )
  • 4.Fiscal Policy
  • The short-run effect of temporary increase

53
Chapter 16
Figure 16 -10 Effects of a Temporary
Increase in the Money Supply
54
Chapter 16
  • (1)in the output market
  • G
  • the aggregate demand for domestic goods
  • D
  • Y
  • (2)in the money market
  • Y L(R,Y) R
  • (3)in the foreign exchange market
  • R E

55
Chapter 16
  • the short-run effectE , Y
  • (Figure 16-11) (E1,Y1 ) (E2,Y2 )
  • 5.Policies to Maintain Full Employment
  • (1)Figure 16-12
  • Suppose the economys initial equilibrium
    is
  • at point 1,where output equals its full-
  • employment level.(Yf)
  • (2)case1a temporary shift in consumers
  • tastes away from domestic products(1
    2)

56
Chapter 16
Figure 16 -11 Effects of a Temporary
Fiscal Expansion
57
Chapter 16
  • CD D Y L(R,Y)
    R E
  • DD1 DD2
  • restoring full-employment policy Figure 16-12
  • (i)the expansion fiscal policy(point 2
    1)
  • DD2 DD1 E,Y
    return the
  • initial level
  • (ii)the expansion monetary policy(point 2
    3)
  • AA1 AA2 E ,Y
    returns the
  • initial level

58
Chapter 16
Figure 16 -12 Maintaining Full Employment
After a Temporary Fall in World Demand for
Domestic Products
59
Chapter 16
  • (3)case 2a temporary increase in the demand
  • for money (point 1
    2)
  • L(R,Y) R E
    q CA
  • D Y (AA1
    AA2 )
  • restoring full-employment policy
  • Figure 16-13
  • (i)the expansion fiscal policy(point 2
    3)
  • DD1 DD2 E
    ,Y returns the
  • initial level.

60
Chapter 16

61
Chapter 16
  • (ii)the expansion monetary policy
  • AA2 AA1 E ,Y
    returns
  • the initial level
  • 6.Inflation Bias and Other Problems of Policy
  • Formulation
  • (1)inflation bias from the expectation that
  • people anticipate the political policies
  • (2)It is hard to be sure whether a disturbance
    to the economy originates in the output or asset
    markets.

62
Chapter 16
  • (3)Real-world policy choices are frequently
    determined by bureaucratic necessities rather
    than by detailed consideration of whether shocks
    to the economy are real.
  • (4)Fiscal policies impact on the government
    budget.
  • (5)time lags of varying length

63
Chapter 16
  • Permanent Shifts in Monetary and
  • Fiscal policy
  • 1.assumptionRR, EEe the economy is
  • initially at a long-run equilibrium position
  • 2.A permanent policy shifts affects not only
  • the current value of the governments policy
  • instrument but also the long-run expected
  • exchange rate.

64
Chapter 16
  • 3. A Permanent Increase in the Money Supply
  • (1)the short-run effect (Figure 16-14)
  • (i)A permanent increase in Ms must
    ultimately
  • lead to a proportional rise in E .The
    rise in
  • Ms causes Ee to rise proportionally.
  • (ii)Because a rise in Ee, the upward shift
    of
  • AA1 to AA2 (permanent) is greater
    than
  • caused by an equal, but transitory,
    increase.
  • (point 3)
  • (iii) E , Y , Y2 gt Yf

65
Chapter 16
Figure 16 -14 Short-Run Effects of a
Permanent Increase in the Money Supply
66
Chapter 16
  • (2)the adjustment to the long run
  • (Figure 16-15)
  • (i) Y2 gt Yf working overtime
  • W AC P
  • (ii)the output market
  • P q CA
    D Y
  • DD shifts left (DD1 DD2)
  • (iii)the money market

67
Chapter 16
  • P Ms/P ED
    R
  • (iv)the foreign exchange market
  • R buying domestic currency
    E
  • AA shifts left (AA2 AA3)
  • (v) E , Y returns to Yf
  • E1 E2 E3
    overshooting
  • (vi)money neutrality (?????)
  • E and P rise in proportion to the
    increase
  • in the money. (Y returns to Yf )

68
Chapter 16
Figure 16-15 Long-Run Adjustment to a
Permanent Increase in the Money Supply
69
Chapter 16
  • 4.A Permanent Fiscal Policy
  • (1)the direct effect
  • G D , DD shifts right (DD1
    DD2) E
  • (2)the indirect effect (E moves immediately)
  • G Ee , AA shifts left(AA1
    AA2)
  • E falls again.
  • (3)E ,Y returns to Yf

70
Chapter 16
Figure 16-16 Effects of a Permanent
Fiscal Expansion
71
Chapter 16
  • (4)conclusion
  • If the economy starts at long-run
    equilibrium, a permanent change in fiscal policy
    has no net effect on output. Instead, it causes
    an immediate and permanent exchange rate jump
    that offsets exactly the fiscal policys direct
    effect on aggregate demand.

72
Chapter 16
  • Macroeconomic Policies and the Current Account
  • 1.the reasons of concerning the current account
  • (1)an excessive imbalance in CA may have
    undesirable long-run effects on national welfare.
  • (2)Large external imbalances may generate
    political pressures for government restrictions
    on trade.

73
Chapter 16
  • 2.The AA-DD-XX model (Figure 16-17)
  • (1)XX curvethe current account balance would
    be equal some desired level, X
  • (2)XX is flatter than DD
  • As we increase Y in moving up along DD,
  • the domestic demand for domestic output
  • rises by less than the rise in output
    itself
  • (since some income is saved and some

74
Chapter 16
  • spending falls on imports). Along DD total
    aggregate demand has to equal supply. To prevent
    an excess supply of home output, E must rise
    sharply enough along DD to make export demand
    rise faster than imports.
  • Given P and P , CA rises if E rises.

75
Chapter 16
  • (3)the expansionary monetary policy (point 2)
  • The rise in Ms causes the AA schedule
    shifting right. Since point 2 lies above XX, the
    CA gt X, the current account improves.
  • conclusion Monetary expansion causes the
    current account balance to increase in the short
    run.
  • (4)the expansionary fiscal policy (point 4)
  • The rise in G causes the DD schedule

76
Chapter 16
  • shifting right (point 3). E falls and Y
    rises, then
  • CA falls. AA shifts left (point 4). Point 3
    and
  • point 4 are below XX, the current account
  • worsens. XX shift downward.
  • conclusionExpansionary fiscal policy
    reduces
  • the current account balance.

77
Chapter 16
Figure 16-17 How Macroeconomics Policies Affect
the Current Account
78
Chapter 16
  • shifting right (point 3). E falls and Y
    rises, then
  • CA falls. AA shifts left (point 4). Point 3
    and
  • point 4 are below XX, the current account
  • worsens. XX shift downward.
  • conclusionExpansionary fiscal policy reduces
  • the current account balance.

79
Chapter 16
  • Gradual Trade Flow Adjustment and Current
    Account Dynamics
  • 1.The J-curve (Figure 16-18)
  • (1)definitionIf the current account initially
  • worsens after a depreciation, its time
    path
  • has an initial segment reminiscent of a J.
  • (2)The current account can deteriorate sharply
  • right after a real currency depreciation
  • because most import and export orders are
  • placed several months in advance. (1
    2)

80
Chapter 16
Figure 16-18 The J-Curve
81
Chapter 16
  • (3)The primary effect of the depreciation is to
    raise the value of the precontracted level of
    imports in terms of domestic products. Because
    exports measured in domestic output do not change
    while imports measured in domestic output rise,
    there is an initial fall in the current account.
  • (4)Empirical evidence indicates for most
    industrial countries a J-curve lasting more than
    six months but less than a year.

82
Chapter 16
  • 2.Exchange rate Pass-Through and Inflation
  • (1)definitionThe percentage by which import
    prices rise when the home currency depreciates by
    one percent is known as the the degree of
    pass-through from the exchange rate to import
    prices.
  • (2)Because the AA-DD model assumes that
  • the nominal output prices P and P cannot
    suddenly jump, movements in q correspond
    perfectly in the short run movements in E.

83
Chapter 16
  • (3)In reality the short-run correspondence
    between q and E movements is less than perfect.
    Exchange rate pass-through is
    incomplete.

84
Chapter 16
  • Problem
  • 3.Imagine that Congress passes a constitutional
  • amendment requiring the U.S. government to
  • maintain a balanced budget at all times.Thus,
    if
  • the government wishes to change government
  • spending, it must change taxes by the same
  • amount, that is, always.
    Does the
  • constitutional amendment imply that the

85
Chapter 16
  • government can no longer use fiscal policy to
  • affect employment and output ?(HintAnalyze
  • a balanced-budget increase in government
  • spending, one that is accompanied by an equal
  • tax hike.)

86
Chapter 16
  • Answer
  • A temporary fiscal policy shift affects
  • employment and output, even if the
  • government maintains a balanced budget.
  • T C lt G (MPClt1)

87
Chapter 16
  • Appendix I to Chapter 16
  • The IS-LM Model and The DD-AA Model
  • 1.The IS-LM model is a short-run equilibrium.
  • 2.the usefulness of IS-LM model
  • allowing the real domestic interest rate (r)
    to
  • affect aggregate demand
  • 2.assumptionP, P, G, T, R, Ee are given

88
Chapter 16
  • the consumption negative response to the
  • expected real interest rate is weaker than the
  • investment negative response.
  • 3.aggregate demand function

89
Chapter 16
  • 4.definition
  • (1)the IS curvethe output market equilibrium
  • (i)from IRP R R (Ee - E )/E

90
Chapter 16
  • (ii)assumption
  • (iii)a fall in the nominal interest rate
    (R) raises
  • D through two channels
  • (iv)from (iii) , the slope of the IS curve
    is
  • negative
  • (2)the LM curvethe money market equilibrium

91
Chapter 16
  • the slope of the LM curve is positive
  • (3)The intersection of the IS and LM curves at
  • point 1 in Figure 16AI-1 determines the
  • short -run equilibrium values of output and
  • the nominal interest rate.The equilibrium
  • interest rate, in turn, determines a
    short-run
  • equilibrium exchange rate through the
  • interest parity condition.

92
Chapter 16
Figure 16AI-1 Short-Run Equilibrium in the
IS-LM Model
93
Chapter 16
  • 5.the effects of monetary policy
  • Figure 16I-2 the right side IS-LM model
  • the left side IRP
    condition
  • (1)temporary increase in the money supply
  • Ee is given, LM curve shifts right,R ,Y
    ,E
  • (R1,Y1 ,E1 ) (R3,Y3,E3 )
  • (2)permanent increase in the money supply
  • Ms increase, LM curve shifts right
  • Ee , IRP-condition curve shifts outward

94
Chapter 16
  • Ee , IS curve shifts right , IS1
    IS2
  • The short-run equilibrium is at point 2.
  • The new equilibrium values of Y and R are
  • higher than that at the equilibrium
    following
  • an equal temporary increase.
  • (R1,Y1 ,E1 ) (R2,Y2 ,E2 )
  • 6.the effects of fiscal policy
  • Figure 16I-3

95
Chapter 16
Figure 16AI-2 Effects of Permanent and
Temporary Increases in the Money Supply in the
IS-LM Model
96
Chapter 16
  • (1)temporary increase in G
  • Ee is given, IS curve shifts right,R ,Y
    ,E
  • (R1,Yf ,E1 ) (R2,Y2,E2 )
  • (2)permanent increase in G
  • G increase, IS curve shifts right
  • Ee , IRP-condition curve shifts inward
    and
  • IS curve turns back
  • (R1,Y2 ,E1 ) (R1,Yf,E3 ) , E

97
Chapter 16
Figure 16AI-3 Effects of Permanent and
Temporary Fiscal Expansions in the IS-LM Model
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