Download Aggregate demand

A Short-Run Model
of an Open Economy
MBA 774
Macroeconomics
Class Notes - Part 4
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)
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?
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)
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
5
Aggregate Demand and Output
Aggregate
Demand (D)
Aggregate Demand
D(E ,Y-T, I, G)
45o
Real
Income (Y)
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
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
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?
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
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
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
Y2
Y1
Y2
12
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
13
Example: Increase in
Government Spending
Nominal Exchange
Rate (E)
E0
DD1
1
Y1
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)
15
The AA Schedule
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
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)
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
19
Short-Run equilibrium
Nominal Exchange
Rate (E)
DD
E2
E3
E1
2
3
1
AA
Y1
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
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
Y2
Output
22
Fiscal Policy
• How does a temporary fiscal expansion (higher G and/or
lower T) affect the equilibrium of an open economy?
DD1
E
E1
DD2
1
2
E2
AA
Y1
Y2
Output
23
Fall in World Demand
for Domestic Products
How can monetary policy be used to restore the economy to
its full-employment output level after a decline in the
world demand for domestic products?
E
Monetary
Expansion
E3
E2
DD1
DD2
Drop in World
Demand
3
2
AA2
1
E1
AA1
Y2
Yf
Output
24