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Chapter 16 Output And The Exchange Rate In The Short Run • Determinants Of Aggregate Demand In An Open Economy Yd = Y –T C = C(Yd) CA = EX – IM = CA ( * EP /P, d Y) where d Y is disposable income, E is the price of foreign currency in terms of domestic . P* is the foreign price level, and P is the home price level. Change Effect on current account , CA EP*/p ↑ CA ↑ EP*/p ↓ CA ↓ Yd ↑ CA ↓ Yd ↓ CA ↑ • The Equation Of Aggregate Demand D = C( Y – T)+ I + G + CA( EP*/P, Y – T) D= * D(EP /P, Y –T, I , G) A real depreciation of the home currency raises aggregate demand for home output, other things equal; a real appreciation lowers aggregate demand for home output. A rise in domestic real income raises aggregate demand for home output, other things equal, and a fall in domestic real income lowers aggregate demand for home output. •Output Market Equilibrium In The Short Run Aggregate demand,D D=Y D 1 D1 45° Y1 Output, Y Output,the Exchange Rate,and Output Market Equilibrium Figure 16-3 Output Effect of a Currency Depreciation with Fixed Output Price D=Y Currency depreciates Aggregate demand,D Aggregate 2 demand (E ) Currency depreciates Aggregate 2 1 demand(E ) 1 Output,Y Y1 Y2 Output Effect of a Currency Depreciation with Fixed Prices Deriving the DD Schedule Figure 16-4 Deriving the DD Schedule D=Y Aggregate demand, D Aggregate demand (E2) Aggregate demand(E1) Exchange Rate Output, Y Y 1 2 Exchange Rate, E 2 E E1 DD 2 1 . Output, Y 1 YY2 • Factors that shift the DD schedule 1. A change in G ( Figure16-5) G↑→ D↑→ DD rightward 2. A change in T T↑→ Yd↓→ D ↓ → DD leftward 3. A change in I I↑→ D↑→ DD rightward Figure 16-5 Figure 16-5 Government Demand and the Position of the DD Schedule D=Y Aggregate demand, D D(E0P*/P,YAggregate demand curves T,I,G2) Government spending rises D(E0P*/P,YT,I,G1) Government demand Output, Y Y 21 Exchange Rate, E E0 DD1 DD2 2 1 Output, Y Y21 Y 4. A change in P P↑→ EX↓→ D ↓→ DD leftward 5. A change in P* P*↑→IM↓→D↑→DD rightward 6. A change in consumption function C = C(Yd) = C[(1- )Yd] C ↑ → D↑→ DD rightward 7. A demand shift between foreign and domestic goods EX↑, IM↓→D↑→DD rightward Conclusion: Any 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. • Asset Market Equilibrium In The Short Run: The AA Schedule R = R*+ (Ee – E)/E ,where R is the interest rate on domestic currency deposits, R* is the interest rate on foreign currency deposits, Ee is a given expected future exchange rate. Figure 16-6 Output and the Exchange Rate in Asset Market Equilibrium Figure 16-6 Output and the Exchange Rate in Asset Market Equilbrium Dollar/euro exchange rate,E $/€ E $/€ 1 Return on dollar deposits 2' 1' Y Expected return on euro deposits Domestic interest rate, R L(R $ ,Y us ) M s us /P us U.S. real money holdings 2 1 U.S. real money supply Conclusion: For asset markets to remain in equilibrium, a rise in domestic output must be accompanied by an appreciation of the domestic currency, all else equal, and a fall in domestic output must be accompanied by a depreciation. Deriving the AA Schedule Exchange rate, E 1 E1 2 E2 Y1 Y2 Output, Y The AA Schedule • Factors that shift the AA schedule 1. A change in Ms Ms ↑→ E ↑ → AA upward 2. A change in P P ↑ → Ms/P → R ↑ → E↓ →AA downward 3. A change in Ee Ee ↑→ E ↑ → AA upward 4. A change in R* R*↑ → E ↑ → AA upward 5. A change in real money demand L(R,Y) ↓ →R ↓→ E ↑ → AA upward • Short-Run Equilibrium For An Open Economy: Putting The DD Schedule And AA Schedule Together Figure 16-8 Short-Run Equilibrium:The Intersection of Exchange DD and AA rate,E DD 1 E 1 AA Y1 Output,Y Because asset markets adjust very quickly, the exchange rate jumps immediately from point 2 to point 3 on AA. The economy then moves to point 1 along AA as output rises to meet aggregate demand. Exchange rate,E E 2 E 3 E 1 Figure 16-9 How the Economy Reaches Its Short-Run Equilibrium DD 2 3 1 AA Y1 Output,Y Monetary Policy Exchange rate,E Figure 16-10 Effects of a Temporary Increase in the Money Supply 15 DD 2 E2 E1 1 M oney Supply AA 1 Y1 Y2 Output,Y Fiscal Policy Figure 16-11 Effects of a Temporary Fiscal 0 Exchange Expansion rate,E DD 1 DD 2 1 E1 2 E 2 Fiscal Expansion AA 1 Y1 Y2 Output,Y Policies to Maintain Full Employment 1 Exchange rate,E Figure 16-12 Maintaining Full Employment After a Temporary Fall in World Demand for Domestic Products DD 2 DD 1 E 23 23 E1 1 AA 12 Y2 Yf Outputs,Y World Demand Fall Monetary Expansion Policies to Maintain Full Employment 2 Figure 16-13 Policies to Maintain Full Employment After a MoneyDemand Increase Exchange rate, E Fiscal Expansion 132 E Yf Output, Y e Permanent Shifts in Monetary and Fiscal Policy A permanent policy shift affects not only the current value of the government,s policy instrument but also the long-run exchange rate. A Permanent increase in the Money Supply Figure 16-14 Short-Run Effects of a Permanent Increase in the Money Supply Exchange rate, E Ms 2 3 1 Yf Y2 Output, Y Adjustment to a Permanent increase in the Money Supply Figure 16-15 Long-Run Adjustment to a Permanent Increase in the Money Supply Exchange rate, E P 3 2 1 Yf Y2 Output, Y A Permanent Fiscal Expansion Figure 16-16 Effects of a Permanent Fiscal Expansion Exchange rate, E Fiscal Expansion 123 E Yf Output, Y e Macroeconomic Policies and the Current Account Exchange rate, E Figure 16-17 How Macroeconomic Policies Affect the Current Account Temporary fiscal expansion XX Monetary expansion Permanent fiscal expansion 1324 Output, Y The J-Curve The J-curve describes the time Current account (in lag with which a real currency domestic output unite) depreciation improves the current account. Long-run effect of real depreciation on the 1 3 current account 2 Time Real depreciation End of J-curve takes place and J-curve begins Question Thanks