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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
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