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A Short-Run Model of an Open Economy BA 282 Macroeconomics Class Notes - Part 4 A Short-Run Model of an Open Economy 1 Aggregate Demand Aggregate demand (D) is the amount of a country’s goods and services demanded by households and firms throughout the world Recall GDP = C + I + G + EX - IM = D Each of these components has various sources that determine demand for that factor We will concentrate here on consumption and CA Specifically, let’s assume C = C(YD) and CA = CA(E, YD) A Short-Run Model of an Open Economy 2 Aggregate Demand and CA To see how a change in E effects CA we look at EX and IM Separately. Assume an increase in E This results in an increase in EX since domestic goods look cheaper to foreigners This can result in an increase or decrease in IM. Why? (for now assume an increase in E results in a decrease of IM) An increase in YD will decrease CA. Why? A Short-Run Model of an Open Economy 3 Aggregate Demand We can now write a more general function for D D = C(Y-T) + I + G + CA(E , Y-T) where Consumption demand (C) is a function of YD YD = Y - T (T = aggregate taxes) or more generally D = D(E , Y-T, I, G) A Short-Run Model of an Open Economy 4 Aggregate demand Let’s review D = D(E , Y-T, I, G) Increasing the real exchange rate increases D through the current account Increasing income will increase D through increases in consumption demand decrease D through increasing import demand The consumption demand effect will be greater then the import demand effect so an increase in income will increase aggregate demand Increasing investment demand I increases D Increasing government demand G increases D A Short-Run Model of an Open Economy 5 Aggregate Demand and Output Aggregate Demand (D) Aggregate Demand D(E ,Y-T, I, G) 45o Real Income (Y) A Short-Run Model of an Open Economy 6 Equilibrium in the Output Market Equilibrium in the domestic output market will occur when aggregate demand equals output (real income) In the short-run we consider prices fixed In the long-run prices will adjust A Short-Run Model of an Open Economy 7 Equilibrium in the Output Market Aggregate Demand (D) Aggregate Demand (D) = Aggregate Output (Y) 3 D3 1 D1 D2 Aggregate Demand D(E ,Y-T, I, G) 2 45o Y2 A Short-Run Model of an Open Economy Y1 Y3 Output (Y) 8 The DD Schedule Now we need to derive the relationship between the exchange rate and output (the DD schedule) when the output market is in equilibrium To do this consider an increase in the nominal exchange rate from E1 to E2 This will increase aggregate demand. Why? A Short-Run Model of an Open Economy 9 Equilibrium Output after Currency Depreciation Aggregate Demand (D) Aggregate Demand D(E2 ,Y-T, I, G) 2 D2 Aggregate Demand D(E1 ,Y-T, I, G) 1 D1 Currency Depreciation 45o Y1 A Short-Run Model of an Open Economy Y2 Output (Y) 10 Deriving the DD Schedule By noting the short-run equilibrium level in the output market for all levels of the nominal exchange rate we derive the DD schedule Intuitively, the DD schedule allows us to see how short-run fluctuations in the nominal exchange rate impact aggregate domestic demand A Short-Run Model of an Open Economy 11 Deriving the DD Schedule Nominal Exchange Rate (E) D DD D2 2 D(E2) D1 1 D(E1) 2 E2 E1 1 Output 45o Y1 A Short-Run Model of an Open Economy Y2 Y1 12 Y2 What Factors Shift the DD Curve? Recall where the DD curve comes from D(E ,Y-T, I, G) So all of the following can shift the DD curve Disposable income Investment Government spending (and taxes) The consumption function A demand shift between foreign and domestic consumption A Short-Run Model of an Open Economy 13 Example: Increase in Government Spending Nominal Exchange Rate (E) E0 1 Y1 A Short-Run Model of an Open Economy DD1 DD2 2 Y2 Output 14 The AA Schedule The AA schedule relates exchange rates and output levels that keep the money and foreign exchange (asset) markets in equilibrium We start with the interest parity condition (with RFC and Ee held constant), RLC = RFC + (Ee-E)/E and the equilibrium money market equation MS/PLC = L(RLC,Y) Now recall money and exchange rate market equilibrium from chapter 14 and an increase in output (Y) A Short-Run Model of an Open Economy 15 The AA Schedule A Short-Run Model of an Open Economy 16 The AA Schedule So in the short run, an increase in output decreases the exchange rate Nominal Exchange Rate (E) E1 1 2 E2 AA Y1 A Short-Run Model of an Open Economy Y2 Output 17 The AA Schedule The AA schedule describes how exchange rates fall as output increases Changes in output will result in a movement along this curve Anything that changes the stacked graphs – the foreign exchange market and money market – except output will shift the curve A change in MS for a fixed level of Y A change in Ee A change in the foreign interest rate RFC A change in the real money demand function L(RLC, Y) A Short-Run Model of an Open Economy 18 Short-Run Equilibrium We now have separate models for exchange-rate equilibrium in the Output market (the DD schedule) Asset market (the AA schedule) We can combine these to get a short-run equilibrium for the whole economy This will be the intersection of the AA and DD schedules To see why this is the equilibrium consider an exchange rate above the AA schedule and on the left of the DD schedule A Short-Run Model of an Open Economy 19 Short-Run equilibrium Nominal Exchange Rate (E) DD E2 E3 2 3 E1 1 AA Y1 A Short-Run Model of an Open Economy Output 20 Applications of DD-AA Model Now that we have a general model of short-run equilibrium we can use it to explore the impact of various economic changes such as Changes in fiscal and monetary policy Changes in world demand for domestic products Changes in money-demand A Short-Run Model of an Open Economy 21 Monetary Policy How does a temporary increase in the domestic money supply affect the equilibrium of an open economy? E DD 2 E2 E1 1 AA2 AA1 Y1 A Short-Run Model of an Open Economy Y2 Output 22 Fiscal Policy How does a temporary fiscal expansion (higher G and/or lower T) affect the equilibrium of an open economy? E E1 DD2 DD1 1 2 E2 AA Y1 A Short-Run Model of an Open Economy Y2 Output 23 Fall in World Demand for Domestic Products How can monetary policy be used to restore the economy to its fullemployment output level after a decline in the world demand for domestic products? E DD1 DD2 Monetary Expansion E3 E2 Drop in World Demand 3 2 AA2 1 E1 AA1 Y2 A Short-Run Model of an Open Economy Yf Output 24