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Transcript
AGGREGATE DEMAND-AGGREGATE SUPPLY MODEL Be sure to read the relevant sections of Chapters 15 and 19 in the textbook (see syllabus). If you lose this handout, you may download a copy from my website: webpages.shepherd.edu/lkinney AGGREGATE DEMAND – THE BUYER’S SIDE OF THE MACROECONOMY AGGREGATE DEMAND CURVE – a relationship between the price level (P) and the aggregate quantity of domestically-produced goods and services (real output = Q) that buyers are willing to purchase. The inverse relationship between the price level and the quantity of goods and services people desire to purchase is based on the behavior of buyers as reflected in the GOODS and MONEY MARKETS. GOODS MARKET – The simple Keynesian Model. EQUILIBRIUM: Q = C + I + G (XGS – IMPGS) E NOTE: 1. 2. 3. 4. Aggregate demand increases when C, I, G, or X increases or IMP decreases. I is inversely related to the interest rate (i). X GS are positively related to foreign real income (Q*) and inversely related to the real exchange rate (R = P/(e$ per SF1P*)) IMPGS are positively related to Q and R. E A E = C + I + G (XGS – IMPGS) 45o Q1 Q MONEY MARKET – The money market is in EQUILIBRIUM at the interest rate where the real quantity of money supplied = the real quantity of money demanded; M/P = L(Q,i). This is demonstrated in the following diagram. 2 i M/P Real Quantity of Money Supplied A i1 L(Q,i) Real Quantity of Money Demanded NOTE: 1. The real quantity of money demanded is the level of purchasing power people desire to hold. It is positively related to real income (Q) and inversely related to the interest rate (i). 2. The real quantity of money supplied is the actual purchasing power of the nominal money supply. It is positively related to the nominal money supply (M) and inversely related to the price level (P). The nominal money supply is assumed to be the sum of domestic currency in the hands of the public and checkable deposits at commercial banks. The size of the nominal money supply (M) is determined by the Central Bank’s monetary policy. The Central Bank can change the nominal money supply by buying and selling domestic government bonds (GB) or foreign exchange reserves (FXR). The equation below summarizes this: M= mm Money Multiplier x( GB + FXR ) Central Bank’s Central Bank’s holdings of holdings of domestic foreign exchange government reserves bonds The equation says that when the Central Bank buys government bonds or foreign exchange reserves, the domestic money supply increases by a multiple of the amount of bonds or foreign exchange reserves purchased. When the Central Bank sells government bonds or foreign exchange reserves, the domestic money supply falls. 3 DERIVATION OF AGGREGATE DEMAND CURVE (AD) UNDER FIXED EXCHANGE RATES P A P1 Q1 I M1/P1 Q E A E Q1 Q A i1 L P ==>i ==> I ==> Q P ==>R ==> XGS & IMPGS ==> Q ** UNDER FLEXIBLE EXCHANGE RATES, the AD curve is still downward sloping, but changes in P (and therefore the relative prices of domestic and foreign goods and services) affect “THE” BOP and therefore change the nominal exchange rate (e). Thus, the slope of the AD curve reflects changes in e that result from changing prices.** 4 CHANGES IN FACTORS OTHER THAN THE PRICE LEVEL (P) SHIFT THE AD CURVE. Of particular note are changes in fiscal and monetary policy. DECREASE AD ==> SHIFT LEFT 1. Decrease M (contractionary monetary policy). 2. Decrease G or increase T (contractionary fiscal policy) INCREASE AD ==> SHIFT RIGHT 1. Increase M (expansionary monetary policy). 2. Increase G or decrease T (expansionary fiscal policy) AGGREGATE SUPPLY – THE PRODUCER’S SIDE OF THE MACROECONOMY AGGREGATE SUPPLY CURVE – a relationship between the price level (P) and the aggregate quantity of goods and services (real output = Q) that producers are willing to produce. It reflects the behavior of firm owners who hire inputs and of input suppliers: workers, owners of capital, sellers of natural resources and energy. THE MEDIUM-RUN AGGREGATE SUPPLY CURVE The aggregate supply curve is upward-sloping in the MEDIUM-RUN, i.e. an increase in the price level (P) will increase the quantity of goods and services produced (Q). An increase in the price level means that producers are receiving higher prices on average for the products they sell. Other things constant, this gives firms an incentive to produce more output. The medium-run aggregate supply curve (MRAS) is often drawn steeper as real output (Q) increases (see below). This is because a given increase in the price level will increase output more when output and employment are low (i.e. below full-employment levels) than when they are high (i.e. near full-employment levels). P MRAS Q 5 SHIFTING THE MEDIUM-RUN AGGREGATE SUPPLY CURVE The most important factor that shifts the medium-run aggregate supply curve is a change in the price or cost of an input which, in turn, changes the costs of production. As a result, producers will alter how much they produce at given price levels. SHIFT MRAS LEFT Increase in costs of production (increase in wage rates, energy costs, prices of natural resources) MRAS’ P SHIFT MRAS RIGHT Decrease in costs of production (decrease in wage rates, energy costs, prices of natural resources) MRAS P MRAS Increase costs MRAS’ Decrease costs Q Q THE LONG-RUN AGGREGATE SUPPLY CURVE The aggregate supply curve is drawn as a vertical line in the LONG-RUN because we assume that in the long-run, the economy operates at its fullemployment level of output, which is assumed fixed in this model. P LRAS Qf Full-employment output Q 6 LONG-RUN EQUILIBRIUM OCCURS WHEN THE AD AND MRAS CURVES CROSS AT THE FULL-EMPLOYMENT LEVEL OF OUTPUT LRAS MRAS P P1 A AD Qf Q THE MAJOR LESSON OF THE EXERCISES BELOW IS THAT OUTPUT CAN BE ABOVE OR BELOW THE FULL-EMPLOYMENT LEVEL TEMPORARILY (i.e. IN THE MEDIUM-RUN). HOWEVER, THE AUTOMATIC ADJUSTMENT MECHANISM MOVES OUTPUT TO THE FULL-EMPLOYMENT LEVEL IN THE LONG-RUN. Exercise 1: Central Bank increases the money supply (expansionary monetary policy). LRAS MRAS P P1 A AD Qf Q 7 Exercise 2: The foreign price level decreases, making domestic goods relatively expensive. Thus, exports decrease and imports increase, reducing the demand for domestic goods. LRAS MRAS P P1 A AD Qf Q Exercise 3: Expansionary fiscal and monetary policy can reverse a recession more quickly than the automatic adjustment mechanism. P LRAS P1 MRAS A AD Q1 Qf Q 8 THE IMPACT OF THE EXCHANGE RATE REGIME AND CAPITAL FLOWS We have not yet considered the impact on the macroeconomy of the type of exchange rate regime or of inflows and outflows of international investment capital. MEDIUM-RUN POLICY GOALS IN THE OPEN ECONOMY: 1. INTERNAL BALANCE: Full-employment and stable prices. 2. EXTERNAL BALANCE: The nominal exchange rate (e) is such that the foreign exchange market is in equilibrium and thus “THE” domestic BOP = 0. For example, external balance for the U.S. implies that “THE” US BOP = CAB + KAB = 0, where CAB = Autonomous US XGS – Autonomous US IMPGS And KAB = Autonomous US XA – Autonomous US IMPA. If “THE” US BOP =0, the current foreign exchange rate between the US dollar and foreign currencies (say, the Swiss franc) is at the equilibrium level (e1 or $.60 per SF in the diagram below). SSF e$ per SF1 “THE” US BOP > 0 EXCESS SUPPLY OF SF/EXCESS DEMAND FOR $ e2 “THE” US BOP = CAB + KAB = 0 $.60 = e1 DSF e3 “THE” US BOP < 0 EXCESS DEMAND FOR SF/EXCESS SUPPLY OF $ Q of SF “THE” BOP changes when there is a change in either the CAB or the KAB, ceteris parabis. In turn, the following functions summarize the factors that change the CAB and KAB. (+) (-) (-) CAB = US XGS – US IMPGS = f(Q*,Q, R) (-) (+) (-) KAB = US XA – US IMPA = g(i*, i, ee$per SF1) variables from uncovered interest arbitrage If “THE” US BOP is not “balanced” (i.e. “THE” BOP 0) and therefore there is either excess demand for or supply of foreign currency (see diagram above), either the nominal exchange rate will move or the government must intervene to keep the exchange rate at the current level. 9 Politicians tend to prefer fiscal and monetary policies that increase national production and employment. Thus, they have a fondness for expansionary fiscal and monetary policies: tax cuts, increases in government programs and spending, and “loose” monetary policy that keeps interest rates low. However, in the open economy, the requirements for achieving external balance can prevent expansionary fiscal and monetary policies from increasing production. Whether expansionary fiscal and monetary policies increases production or not depends on (1) the type of exchange rate regime the nation has and on (2) the degree of international capital mobility. 1. Type of Exchange Rate Regime When the exchange rate is fixed, the Central Bank must respond to imbalances in “THE” BOP and therefore excess demand for or excess supply of foreign currency by buying or selling foreign currency from its foreign exchange reserves to maintain the currency’s value and thus external balance. This in turn changes the nominal domestic money supply: M= mm Money Multiplier x( GB + FXR ) Central Bank’s Central Bank’s holdings of holdings of domestic foreign exchange government reserves bonds SSF e$ per SF1 “THE” US BOP > 0 EXCESS SUPPLY OF SF/EXCESS DEMAND FOR $ e2 e3 CB BUYS FXR (SF) INCREASE M ($) DSF “THE” US BOP < 0 EXCESS DEMAND FOR SF/EXCESS SUPPLY OF $ CB SELLS FXR (SF) DECREASE M ($) Q of SF For example, if the exchange rate is fixed at e3 in the diagram above, a deficit in the “THE” BOP and corresponding excess demand for foreign currency, will require the Central Bank to sell some of its foreign exchange reserves (SF), reducing its holdings of reserves and thus reducing the domestic money supply ($). Similarly, if the exchange rate is fixed at e2, the Central Bank will have to buy foreign currency (SF) which will increase the nominal domestic money supply ($). Thus, if an expansionary fiscal or monetary policy produces an imbalance in “THE” BOP, the domestic money supply may have to change to restore external 10 balance if the nation operates under a fixed exchange rate regime. The resulting change in aggregate demand due to the money supply change may offset the impact of the fiscal or monetary policy on aggregate demand. If the exchange rate is flexible, maintaining external balance requires that the nominal exchange rate automatically move in response to imbalances. SSF e$ per SF1 e2 SF dep/S app SF app/$ dep e3 “THE” US BOP > 0 EXCESS SUPPLY OF SF/EXCESS DEMAND FOR $ e DECREASES: SF DEPRECIATES/$ APPRECIATES DSF “THE” US BOP < 0 EXCESS DEMAND FOR SF/EXCESS SUPPLY OF $ e INCREASES: SF APPRECIATES/$ DEPRECIATES Q of SF If “THE” BOP > 0 (a surplus), the resulting excess supply of foreign currency will cause the domestic currency ($) to appreciate. A deficit in “THE” BOP will result in a depreciation of the domestic currency. Thus, if expansionary fiscal or monetary policy alters the nominal exchange rate, exports and imports of goods and services and thus aggregate demand can change. The change in aggregate demand due to changes in the exchange rate may offset the effect on aggregate demand of the fiscal or monetary policy. 2. Degree of International Capital Mobility We will assume that capital is perfectly mobile across national borders, i.e. that each nation does not restrict the extent to which capital can move into and out of the country. In this type of environment, even miniscule changes in domestic interest rates relative to foreign interest rates can produce large changes in capital flows between countries. As a result, domestic and foreign interest rates will tend to equalize (when adjusted for risk). 11 EVALUATING THE IMPACT OF FISCAL AND MONETARY POLICIES IN THE MEDIUM RUN IN THE “OPEN ECONOMY” CHANGE IN FISCAL POLICY: 1. Start with AD/AS diagram to see what impact the policy potentially has on domestic aggregate demand and therefore on domestic production and prices in the medium-run. 2. Since the link between the domestic economy and the international economy is the domestic interest rate relative to the foreign interest rate, go to the money market diagram to see what happens to the domestic interest rate. 3. Determine the impact of the policy on external balance: explain what impact the change in domestic interest rates relative to foreign interest rates will have on the KAB and therefore on “THE” BOP. 4. Determine whether the change in “THE” BOP produces an excess demand for or supply of foreign currency, using the foreign exchange market diagram. 5. Indicate the change in the nominal money supply, using the money market diagram (fixed exchange rate regime), or the change in the nominal exchange rate, using the foreign exchange market diagram (flexible exchange rate regime), required to restore external imbalance. 6. Analyze the impact of the restoration of external balance (step 5) on aggregate demand using the AD/AS diagram. CHANGE IN MONETARY POLICY 1. Start with the money market diagram to see what impact the change in the money supply will have the domestic interest rate. 2. Go to the AD/AS diagram to see what impact the policy potentially has on domestic aggregate demand and therefore on domestic production and prices in the medium-run. 3. Determine the impact of the policy on external balance: explain what impact the change in domestic interest rates relative to foreign interest rates will have on the KAB and therefore on “THE” BOP. 4. Determine whether the change in “THE” BOP produces an excess demand for or supply of foreign currency, using the foreign exchange market diagram. 5. Indicate the change in the nominal money supply, using the money market diagram (fixed exchange rate regime), or the change in the nominal exchange rate, using the foreign exchange market diagram (flexible exchange rate regime), required to restore external imbalance. 6. Analyze the impact of the restoration of external balance (step 5) on aggregate demand using the AD/AS diagram.