Topic 7 Output and the Exchange Rate in the Short Run

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Topic 7Output and the Exchange Rate in the
Short Run

• Textbook Chapter 16

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Learning objectives

• Equilibrium relationship between output and the
  exchange rate in output market.
• Equilibrium relationship between output and the
  exchange rate in asset market.
• Short-run policy analysis in an open-economy
  framework.

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Factors determining the current account

• Current account (CA) rises as the dollar
  depreciates in real terms (q/?) and falls as
  the dollar appreciates in real terms (q/?).
• Current account (CA) rises as domestic disposable
  income falls (Yd?) and falls as domestic
  disposable income rises (Yd?).

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Equation of aggregate demand

• Aggregate demand (D) consists of consumption (C),
  investment (I), government expenditure (G), and
  net exports (CA).
• D C(Y-T) I G CA(EP/P, Y-T)
• or DD(EP/P, Y-T, I, G)

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Figure 16-1 Aggregate Demand as a Function of
Output
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Output market equilibrium

• Output market is at the equilibrium if output (Y)
  equals the aggregate demand for domestic output
• Y D,
• or, Y D(EP/P, Y-T, I, G).
• Y will rise if D gtY and fall if D lt Y.

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Figure 16-2 The Determination of Output in the
Short Run
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Output market equilibrium schedule

• The DD schedule is all the pairs of output and
  the exchange rate at which aggregate demand
  equals aggregate output.
• DD curve is upward sloping.
• DD curve shifts to the right (left) if anything
  other than the exchange rate changes so that
  output rises (falls).
• p. 447-448.

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Asset market equilibrium schedule

• The AA schedule is all the pairs of output and
  the exchange rate at which money market clears
  and the interest rate parity holds.
• AA curve is downward sloping.
• AA curve shifts upward (downward) if anything
  other than output changes so that the exchange
  rate rises (falls).
• p. 452.

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Open-economy equilibrium

• An open economy is at its general equilibrium
  when both output and asset markets clear.
• Once the economy is off the equilibrium, the
  exchange rate, driven by IRP, tends to adjust
  immediately and output adjusts later driven by
  inventory change.

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Figure 16-8 Short-Run Equilibrium The
Intersection of DD and AA
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Figure 16-9 How the Economy Reaches Its
Short-Run Equilibrium
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Assumptions for policy analysis

• Policy changes are temporary so that they will
  not change the long-run expected exchange rate.
• Domestic policy changes will not influence the
  foreign interest rate or price level.
• The domestic price level is fixed in the short
  run.

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Policy analysis

• Economic forces in monetary policy analysis (Fig.
  16-10)
• (MS/P)??R??E?(?(Ee-E)/E? IRP condition) ?q? ? D
  ? ? Y ?
• Economic forces in fiscal policy analysis (Fig.
  16-11)
• G??Y??L(R,Y)??R??E ? (?(Ee-E)/E? IRP condition)

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Figure 16-10 Effects of a Temporary Increase in
the Money Supply
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Figure 16-11 Effects of a Temporary Fiscal
Expansion
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Case I Policies to maintain full employment

• A temporary fall in world demand for domestic
  products causes output to fall and the currency
  to depreciate.
• Either monetary expansion or fiscal expansion, or
  both, can pull output back to its full-employment
  level.
• Fiscal expansion restores the currency to its
  original exchange value whereas monetary
  expansion causes the currency to further
  depreciate.

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Figure 16-12 Policies to Maintain Full
Employment after an output-demand decrease
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Case II Policies to maintain full employment

• A temporary rise in the demand for money causes
  output to fall and the currency to appreciate.
• Either monetary expansion or fiscal expansion, or
  both, can pull output back to its full-employment
  level.
• Monetary expansion restores the currency to its
  original exchange value whereas fiscal expansion
  causes the currency to further appreciate.

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A permanent increase in the money supply

• In the short run,
• (MS/P)??R? and Ee? ?E??(IRP condition) ?q??? D??
  ? Y??
• In the long run,
• YgtYf ?P? ? q ? (leftward shift of DD) and (MS/P)
  ?(leftward shift of AA) ? Y? until YYf.

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Figure 16-14 Short-Run Effects of a Permanent
Increase in the Money Supply
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Figure 16-15 Long-Run Adjustment to a Permanent
Increase in the Money Supply
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A permanent fiscal expansion

• Starting at long-run equilibrium (YYf), a
  permanent fiscal expansion has no net effect on
  output. Instead, it causes immediate and
  permanent exchange rate jump that offsets exactly
  the fiscal policys direct effect on aggregate
  demand.
• G?(or T?) ?Y? ? R? ?E ? and Ee ? ?Y ?

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Figure 16-16 Effects of a Permanent Fiscal
Expansion
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The current account curve XX

• The XX curve shows the combinations of the
  exchange rate and output at which the current
  account equals some desired level, say, X.
• XX curve is upward sloping and flatter than DD
  curve.

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Policy impacts on the current account

• Monetary expansion raises the current account
  balance.
• Fiscal expansion reduces the current account
  balance.

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Figure 16-17 How Macroeconomic Policies Affect
the Current Account
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The J curve

• The current account worsens immediately after a
  real depreciation and begins to improve only
  months later the adjustment path is reminiscent
  of a J.
• With the J-curve effect, monetary expansion is
  associated with an output contraction and thus a
  larger fall in the interest rate, thus amplifying
  overshooting.

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Figure 16-18 The J-Curve
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Summary

• At the short-run equilibrium, both output and
  money markets clear and the interest rate parity
  holds.
• Temporary monetary expansion causes output to
  increase and the currency to depreciate fiscal
  expansion leads to an increase in output but a
  currency appreciation.
• If the economy is initially at full employment
  level, permanent monetary and fiscal expansions
  have no net effect on output but impact on
  current account differently.