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

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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

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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.

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Chapter 16

4.Determinants of Consumption Demand
(1)disposable income

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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

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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

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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

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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)

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

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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
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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

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Chapter 16
Figure 16-3 Output Effect of a Currency
Depreciation with Fixed Output Prices
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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

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Chapter 16
Figure 16-4 Deriving the DD Schedule
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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
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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

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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.

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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