Chapter 17 (6) Output And The Exchange Rate In The Short Run

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Chapter 17 (6)Output and theExchange Ratein the Short Run

Preview Determinants of aggregate demand in the short run A short-run model of output markets A short-run model of asset markets A short-run model for both output markets andasset markets Effects of temporary and permanent changes inmonetary and fiscal policies Adjustment of the current account over time IS-LM modelCopyright 2015 Pearson Education, Inc. All rights reserved.17-2

Introduction Long-run models are useful when all prices ofinputs and outputs have time to adjust. In the short run, some prices of inputs and outputsmay not have time to adjust, due to laborcontracts, costs of adjustment, or imperfectinformation about willingness of customers to payat different prices. This chapter builds on the short-run and long-runmodels of exchange rates to explain how output isrelated to exchange rates in the short run.– It shows how macroeconomic policies can affectproduction, employment, and the current account.Copyright 2015 Pearson Education, Inc. All rights reserved.17-3

Determinants of AggregateDemand Aggregate demand is the aggregate amount ofgoods and services that individuals and institutionsare willing to buy:1.2.3.4.consumption expenditureinvestment expendituregovernment purchasesnet expenditure by foreigners: the current accountCopyright 2015 Pearson Education, Inc. All rights reserved.17-4

Determinants of AggregateDemand (cont.) Determinants of consumption expenditure include:– Disposable income: income from production (Y) minustaxes (T).– More disposable income means more consumptionexpenditure, but consumption typically increases less thanthe amount that disposable income increases.– Real interest rates may influence the amount of saving andspending on consumption goods, but we assume that theyare relatively unimportant here.– Wealth may also influence consumption expenditure, butwe assume that it is relatively unimportant here.Copyright 2015 Pearson Education, Inc. All rights reserved.17-5

Determinants ofAggregate Demand (cont.) Determinants of the current account include:– Real exchange rate: prices of foreign products relative tothe prices of domestic products, both measured indomestic currency: EP*/P As the prices of foreign products rise relative to those ofdomestic products, expenditure on domestic products rises,and expenditure on foreign products falls.– Disposable income: more disposable income meansmore expenditure on foreign products (imports).Copyright 2015 Pearson Education, Inc. All rights reserved.17-6

Table 17-1: Factors Determining theCurrent AccountCopyright 2015 Pearson Education, Inc. All rights reserved.17-7

How Real Exchange Rate ChangesAffect the Current Account The current account measures the value ofexports relative to the value of imports:CA EX – IM.–When the real exchange rate EP*/P rises, the pricesof foreign products rise relative to the prices ofdomestic products.1. The volume of exports that are bought by foreignersrises.2. The volume of imports that are bought by domesticresidents falls.3. The value of imports in terms of domestic products rises:the value/price of imports rises, since foreign productsare more valuable/expensive.Copyright 2015 Pearson Education, Inc. All rights reserved.17-8

How Real Exchange Rate ChangesAffect the Current Account (cont.) If the volumes of imports and exports do notchange much, the value effect may dominate thevolume effect when the real exchange ratechanges.– For example, contract obligations to buy fixed amounts ofproducts may cause the volume effect to be small. However, evidence indicates that for most countriesthe volume effect dominates the value effect afterone year or less. Let’s assume for now that a real depreciation leadsto an increase in the current account: the volumeeffect dominates the value effect.Copyright 2015 Pearson Education, Inc. All rights reserved.17-9

Fig. 17-1: Aggregate Demand as aFunction of OutputCopyright 2015 Pearson Education, Inc. All rights reserved.17-10

Determinants of AggregateDemand Determinants of the current account include:– Real exchange rate: an increase in the real exchangerate increases the current account.– Disposable income: an increase in the disposable incomedecreases the current account.Copyright 2015 Pearson Education, Inc. All rights reserved.17-11

Determinants of Aggregate Demand(cont.) For simplicity, we assume that exogenous politicalfactors determine government purchases G and thelevel of taxes T. For simplicity, we currently assume that investmentexpenditure I is determined by exogenous businessdecisions.– A more complicated model shows that investment dependson the cost of spending or borrowing to financeinvestment: the interest rate.Copyright 2015 Pearson Education, Inc. All rights reserved.17-12

Determinants of Aggregate Demand(cont.) Aggregate demand is therefore expressed as:D C(Y – T) I G CA(EP*/P, Y – T)Consumptionexpenditureas a functionof disposableincomeInvestmentexpenditure andgovernmentpurchases, bothexogenousCurrent account asa function of the realexchange rate anddisposable income. Or more simply: D D(EP*/P, Y – T, I, G)Copyright 2015 Pearson Education, Inc. All rights reserved.17-13

Determinants of Aggregate Demand(cont.) Determinants of aggregate demand include:– Real exchange rate: an increase in the real exchangerate increases the current account, and therefore increasesaggregate demand of domestic products.– Disposable income: an increase in the disposable incomeincreases consumption expenditure, but decreases thecurrent account. Since consumption expenditure is usually greater thanexpenditure on foreign products, the first effect dominates thesecond effect. As income increases for a given level of taxes, aggregateconsumption expenditure and aggregate demand increase byless than income.Copyright 2015 Pearson Education, Inc. All rights reserved.17-14

Short-Run Equilibrium for AggregateDemand and Output Equilibrium is achieved when the value ofincome from production (output) Y equals thevalue of aggregate demand D.Y D(EP*/P, Y – T, I, G)Value of outputand income fromproductionAggregate demand as a function of thereal exchange rate, disposable income,investment expenditure and governmentpurchasesCopyright 2015 Pearson Education, Inc. All rights reserved.17-15

Fig. 17-2: The Determination ofOutput in the Short RunCopyright 2015 Pearson Education, Inc. All rights reserved.17-16

Short-Run Equilibrium and theExchange Rate: DD Schedule How does the exchange rate affect the short-runequilibrium of aggregate demand and output? With fixed domestic and foreign levels of averageprices, a rise in the nominal exchange rate makesforeign goods and services more expensive relativeto domestic goods and services. A rise in the nominal exchange rate (a domesticcurrency depreciation) increases aggregate demandof domestic products. In equilibrium, production will increase to matchthe higher aggregate demand.Copyright 2015 Pearson Education, Inc. All rights reserved.17-17

Fig. 17-3: Output Effect of a CurrencyDepreciation with Fixed Output PricesCopyright 2015 Pearson Education, Inc. All rights reserved.17-18

Fig. 17-4:Deriving theDD ScheduleCopyright 2015 Pearson Education, Inc. All rights reserved.17-19

Short-Run Equilibrium and theExchange Rate: DD Schedule (cont.)DD schedule shows combinations of output and the exchangerate at which the output market is in short-runequilibrium (such that aggregate demand aggregate output). slopes upward because a rise in the exchange ratecauses aggregate demand and aggregate output torise.Copyright 2015 Pearson Education, Inc. All rights reserved.17-20

Shifting the DD Curve Changes in the exchange rate cause movementsalong a DD curve. Other changes cause it to shift:1. Changes in G: more government purchasescause higher aggregate demand and output inequilibrium. Output increases for every exchangerate: the DD curve shifts right.Copyright 2015 Pearson Education, Inc. All rights reserved.17-21

Fig. 17-5:GovernmentDemand and thePosition of the DDScheduleCopyright 2015 Pearson Education, Inc. All rights reserved.17-22

Shifting the DD Curve (cont.)2. Changes in T: lower taxes generally increaseconsumption expenditure, increasing aggregatedemand and output in equilibrium for everyexchange rate: the DD curve shifts right.3. Changes in I: higher investment expenditure isrepresented by shifting the DD curve right.4. Changes in P relative to P*: lower domesticprices relative to foreign prices are represented byshifting the DD curve right.Copyright 2015 Pearson Education, Inc. All rights reserved.17-23

Shifting the DD Curve (cont.)5. Changes in C: willingness to consume more andsave less is represented by shifting the DD curveright.6. Changes in demand of domestic goodsrelative to foreign goods: willingness toconsume more domestic goods relative to foreigngoods is represented by shifting the DD curveright.Copyright 2015 Pearson Education, Inc. All rights reserved.17-24

Short-Run Equilibrium in AssetMarkets We consider two sets of asset markets:1. Foreign exchange markets–interest parity represents equilibrium:R R* (Ee – E)/E2. Money market–Equilibrium occurs when the quantity of real monetaryassets supplied matches the quantity of real monetaryassets demanded: Ms/P L(R, Y)–A rise in income from production causes the demand ofreal monetary assets to increase.Copyright 2015 Pearson Education, Inc. All rights reserved.17-25

Fig. 17-6:Output andthe ExchangeRate in AssetMarketEquilibriumCopyright 2015 Pearson Education, Inc. All rights reserved.17-26

Short-Run Equilibrium in AssetMarkets (cont.) When income and production increase,– demand of real monetary assets increases,– leading to an increase in domestic interest rates,– leading to an appreciation of the domesticcurrency. Recall that an appreciation of the domesticcurrency is represented by a fall in E. When income and production decrease, thedomestic currency depreciates and E rises.Copyright 2015 Pearson Education, Inc. All rights reserved.17-27

Short-Run Equilibrium in AssetMarkets: AA Curve The inverse relationship between output andexchange rates needed to keep the foreignexchange markets and the money market inequilibrium is summarized as the AA curve.Copyright 2015 Pearson Education, Inc. All rights reserved.17-28

Fig. 17-7: The AA ScheduleCopyright 2015 Pearson Education, Inc. All rights reserved.17-29

Shifting the AA Curve1. Changes in Ms: an increase in the money supplyreduces interest rates in the short run, causingthe domestic currency to depreciate (a rise in E)for every Y: the AA curve shifts up (right).Copyright 2015 Pearson Education, Inc. All rights reserved.17-30

Shifting the AA Curve (cont.)2. Changes in P: An increase in the level of averagedomestic prices decreases the supply of realmonetary assets, increasing interest rates, causingthe domestic currency to appreciate (a fall in E):the AA curve shifts down (left).3. Changes in the demand of real monetaryassets: if domestic residents are willing to hold alower amount of real money assets and more nonmonetary assets, interest rates on nonmonetaryassets would fall, leading to a depreciation of thedomestic currency (a rise in E): the AA curve shiftsup (right).Copyright 2015 Pearson Education, Inc. All rights reserved.17-31

Shifting the AA Curve (cont.)4. Changes in R*: An increase in the foreigninterest rates makes foreign currency depositsmore attractive, leading to a depreciation of thedomestic currency (a rise in E): the AA curve shiftsup (right).5. Changes in Ee: if market participants expect thedomestic currency to depreciate in the future,foreign currency deposits become more attractive,causing the domestic currency to depreciate (arise in E): the AA curve shifts up (right).Copyright 2015 Pearson Education, Inc. All rights reserved.17-32

Putting the Pieces Together:the DD and AA Curves A short-run equilibrium means a nominalexchange rate and level of output such that1. equilibrium in the output markets holds:aggregate demand equals aggregate output.2. equilibrium in the foreign exchange marketsholds: interest parity holds.3. equilibrium in the money market holds: thequantity of real monetary assets supplied equalsthe quantity of real monetary assets demanded.Copyright 2015 Pearson Education, Inc. All rights reserved.17-33

Putting the Pieces Together:the DD and AA Curves (cont.) A short-run equilibrium occurs at the intersection ofthe DD and AA curves:– output markets are in equilibrium on the DD curve– asset markets are in equilibrium on the AA curveCopyright 2015 Pearson Education, Inc. All rights reserved.17-34

Fig. 17-8: Short-Run Equilibrium: TheIntersection of DD and AACopyright 2015 Pearson Education, Inc. All rights reserved.17-35

Fig. 17-9: How the Economy ReachesIts Short-Run EquilibriumCopyright 2015 Pearson Education, Inc. All rights reserved.17-36

Temporary Changes in Monetary andFiscal Policy Monetary policy: policy in which the central bankinfluences the supply of monetary assets.– Monetary policy is assumed to affect asset markets first. Fiscal policy: policy in which governments(fiscal authorities) influence the amount ofgovernment purchases and taxes.– Fiscal policy is assumed to affect aggregate demand andoutput first. Temporary policy changes are expected to bereversed in the near future and thus do not affectexpectations about exchange rates in the long run.Copyright 2015 Pearson Education, Inc. All rights reserved.17-37

Temporary Changes in MonetaryPolicy An increase in the quantity of monetaryassets supplied lowers interest rates in theshort run, causing the domestic currency todepreciate (E rises).– The AA shifts up (right).– Domestic products relative to foreign productsare cheaper, so that aggregate demand andoutput increase until a new short-run equilibriumis achieved.Copyright 2015 Pearson Education, Inc. All rights reserved.17-38

Fig. 17-10: Effects of a TemporaryIncrease in the Money SupplyCopyright 2015 Pearson Education, Inc. All rights reserved.17-39

Temporary Changes in FiscalPolicy An increase in government purchases or adecrease in taxes increases aggregatedemand and output in the short run.– The DD curve shifts right.– Higher output increases the demand for realmonetary assets, thereby increasing interest rates, causing the domestic currency to appreciate(E falls).Copyright 2015 Pearson Education, Inc. All rights reserved.17-40

Fig. 17-11: Effects of aTemporary Fiscal ExpansionCopyright 2015 Pearson Education, Inc. All rights reserved.17-41

Policies to Maintain FullEmployment Resources used in the production process can either be overemployed or underemployed. When resources are used effectively and sustainably,economists say that production is at its potential or naturallevel.– When resources are not used effectively, resources areunderemployed: high unemployment, few hours worked, idleequipment, lower than normal production of goods and services.– When resources are not used sustainably, labor is over-employed:low unemployment, many overtime hours, over-utilizedequipment, higher than normal production of goods and services.Copyright 2015 Pearson Education, Inc. All rights reserved.17-42

Fig. 17-12: Maintaining Full Employmentafter a Temporary Fall in World Demand forDomestic ProductsCopyright 2015 Pearson Education, Inc. All rights reserved.17-43

Fig. 17-13: Policies to Maintain FullEmployment after a Money DemandIncreaseCopyright 2015 Pearson Education, Inc. All rights reserved.17-44

Policies to Maintain Full Employment(cont.) Policies to maintain full employment may seemeasy in theory, but are hard in practice.1. We have assumed that prices and expectations donot change, but people may anticipate the effectsof policy changes and modify their behavior.–Workers may require higher wages if they expect overtimeand easy employment, and producers may raise prices ifthey expect high wages and strong demand due tomonetary and fiscal policies.–Fiscal and monetary policies may therefore create pricechanges and inflation, thereby preventing high output andemployment: inflationary bias.Copyright 2015 Pearson Education, Inc. All rights reserved.17-45

Policies to Maintain Full Employment(cont.)2. Economic data are difficult to measure and tounderstand.–Policy makers cannot interpret data about asset marketsand aggregate demand with certainty, and sometimesthey make mistakes.3. Changes in policies take time to be implementedand to affect the economy.–Because they are slow, policies may affect the economyafter the effects of an economic change have dissipated.4. Policies are sometimes influenced by political orbureaucratic interests.Copyright 2015 Pearson Education, Inc. All rights reserved.17-46

Permanent Changes in Monetary andFiscal Policy “Permanent” policy changes are those that areassumed to modify people’s expectations aboutexchange rates in the long run.Copyright 2015 Pearson Education, Inc. All rights reserved.17-47

Permanent Changes in MonetaryPolicy A permanent increase in the quantity of monetaryassets supplied has several effects:– It lowers interest rates in the short run and makes peopleexpect future depreciation of the domestic currency,increasing the expected rate of return on foreign currencydeposits.– The domestic currency depreciates (E rises) more than isthe case when expectations are constant (Econ Chapter14/Finance Chapter 3 results).– The AA curve shifts up (right) more than is the case whenexpectations are held constant.Copyright 2015 Pearson Education, Inc. All rights reserved.17-48

Fig. 17-14: Short-Run Effects of aPermanent Increase in the Money SupplyCopyright 2015 Pearson Education, Inc. All rights reserved.17-49

Effects of Permanent Changes inMonetary Policy in the Long Run With employment and hours above their normallevels, there is a tendency for wages to rise overtime. With strong demand for goods and services andwith increasing wages, producers have an incentiveto raise prices over time. Both higher wages and higher output prices arereflected in a higher level of average prices. What are the effects of rising prices?Copyright 2015 Pearson Education, Inc. All rights reserved.17-50

Fig. 17-15: Long-Run Adjustment to aPermanent Increase in the Money SupplyCopyright 2015 Pearson Education, Inc. All rights reserved.17-51

Effects of Permanent Changes inFiscal Policy A permanent increase in government purchases orreduction in taxes– increases aggregate demand– makes people expect the domestic currency to appreciatein the short run due to increased aggregate demand,thereby reducing the expected rate of return on foreigncurrency deposits and making the domestic currencyappreciate. The first effect increases aggregate demand ofdomestic products, the second effect decreasesaggregate demand of domestic products (bymaking them more expensive).Copyright 2015 Pearson Education, Inc. All rights reserved.17-52

Effects of Permanent Changes inFiscal Policy (cont.) If the change in fiscal policy is expected tobe permanent, the first and second effectsexactly offset each other, so that outputremains at its potential or natural (or longrun) level. We say that an increase in governmentpurchases completely crowds out netexports, due to the effect of the appreciateddomestic currency.Copyright 2015 Pearson Education, Inc. All rights reserved.17-53

Fig. 17-16: Effects of a PermanentFiscal ExpansionCopyright 2015 Pearson Education, Inc. All rights reserved.17-54

Macroeconomic Policies and theCurrent Account To determine the effect of monetary and fiscalpolicies on the current account,– derive the XX curve to represent the combinations ofoutput and exchange rates at which the current account isat its desired level. As income from production increases, importsincrease and the current account decreases whenother factors remain constant. To keep the current account at its desired level, thedomestic currency must depreciate as income fromproduction increases: the XX curve should slopeupward.Copyright 2015 Pearson Education, Inc. All rights reserved.17-55

Fig. 17-17: How MacroeconomicPolicies Affect the Current AccountCopyright 2015 Pearson Education, Inc. All rights reserved.17-56

Macroeconomic Policies and theCurrent Account (cont.) The XX curve slopes upward but is flatter than theDD curve.– DD represents equilibrium values of aggregate demand anddomestic output.– As domestic income and production increase, domesticsaving increases, which means that aggregate demand(willingness to spend) by domestic residents does not riseas rapidly as income and production.Copyright 2015 Pearson Education, Inc. All rights reserved.17-57

Macroeconomic Policies and theCurrent Account (cont.)– As domestic income and production increase, the domesticcurrency must depreciate to entice foreigners to increasetheir demand of domestic products in order to keep thecurrent account (only one component of aggregatedemand) at its desired level—on the XX curve.– As domestic income and production increase, the domesticcurrency must depreciate more rapidly to entice foreignersto increase their demand of domestic products in order tokeep aggregate demand (by domestic residents andforeigners) equal to production—on the DD curve.Copyright 2015 Pearson Education, Inc. All rights reserved.17-58

Macroeconomic Policies and theCurrent Account (cont.) Policies affect the current account through theirinfluence on the value of the domestic currency.– An increase in the quantity of monetary assets supplieddepreciates the domestic currency and often increases thecurrent account in the short run.– An increase in government purchases or decrease in taxesappreciates the domestic currency and often decreases thecurrent account in the short run.Copyright 2015 Pearson Education, Inc. All rights reserved.17-59

Value Effect, Volume Effect, and theJ-Curve If the volume of imports and exports is fixed in theshort run, a depreciation of the domestic currency– will not affect the volume of imports or exports,– but will increase the value/price of imports in domesticcurrency and decrease the current account: CA EX – IM.– The value of exports in domestic currency does notchange. The current account could immediately decreaseafter a currency depreciation, then increasegradually as the volume effect begins to dominatethe value effect.Copyright 2015 Pearson Education, Inc. All rights reserved.17-60

Fig. 17-18: The J-CurveCopyright 2015 Pearson Education, Inc. All rights reserved.17-61

Value Effect, Volume Effect, and the JCurve (cont.) Pass-through from the exchange rate to importprices measures the percentage by which importprices change when the value of the domesticcurrency changes by 1%. In the DD-AA model, the pass-through rate is100%: import prices in domestic currency exactlymatch a depreciation of the domestic currency. 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 inthe exchange rate with changes in prices of foreignproducts denominated in domestic currency.Copyright 2015 Pearson Education, Inc. All rights reserved.17-62

Value Effect, Volume Effect, and the JCurve (cont.) If prices of foreign products in domestic currencydo not change much because of a pass-throughrate less than 100%, then– the value of imports will not rise much after a domesticcurrency depreciation, and the current account will not fallmuch, making the J-curve effect smaller.– the volume of imports and exports will not adjust muchover time, since domestic currency prices do not changemuch. Pass-through of less than 100% dampens the effectof depreciation or appreciation on the currentaccount.Copyright 2015 Pearson Education, Inc. All rights reserved.17-63

Fig. 17-19: A Low-Output LiquidityTrapCopyright 2015 Pearson Education, Inc. All rights reserved.17-64

Summary1. Aggregate demand is influenced by disposableincome and the real exchange rate.2. The DD curve shows combinations of exchangerates and output where aggregate demand aggregate output.3. The AA curve shows combinations of exchangerates and output where the foreign exchangemarkets and money market are in equilibrium.Copyright 2015 Pearson Education, Inc. All rights reserved.17-65

Summary (cont.)4.In the DD-AA model, we assume that adepreciation of the domestic currency leads to anincrease in the current account and aggregatedemand.5.But reality is more complicated, and theJ-curve shows that the value effect at firstdominates the volume effect.Copyright 2015 Pearson Education, Inc. All rights reserved.17-66

Summary (cont.)6. A temporary increase in the money supply ispredicted to increase output and depreciate thedomestic currency.7. A permanent increase does both to a largerdegree in the short run, but in the long runoutput returns to its normal level.8. A temporary increase in government purchases ispredicted to increase output and appreciate thedomestic currency.9. A permanent increase in government purchases ispredicted to completely crowd out net exports,and therefore to have no effect on output.Copyright 2015 Pearson Education, Inc. All rights reserved.17-67

Chapter 17 (6)Appendix 1:IntertemporalTrade andConsumptionDemand

Fig. 17A1-1: Change in Output andSavingCopyright 2015 Pearson Education, Inc. All rights reserved.17-69

Chapter 17 (6)Appendix 2: TheMarshall-LernerCondition andEmpirical Estimatesof Trade Elasticities

Table 17A2-1: Estimated Price Elasticitiesfor International Trade in ManufacturedGoodsCopyright 2015 Pearson Education, Inc. All rights reserved.17-71

A short-run equilibrium means a nominal exchange rate and level of output such that 1. equilibrium in the output markets holds: aggregate demand equals aggregate output. 2. equilibrium in the foreign exchange markets holds: interest parity holds. 3. equilibrium in the money market ho