Download INTERNATIONAL FACTOR MOVEMENT

Chapter 27
Prices and
Output in the
Open Economy:
Aggregate
Supply and
Demand
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
 Explain the fundamental links between
international transactions and aggregate
supply and aggregate demand.
 Demonstrate how economic shocks and
policies affect prices and output.
 Differentiate between macroeconomic
adjustment under fixed exchange rates and
under flexible exchange rates.
 Distinguish between short-run and long-run
effects of macro policies on output and
prices.
27-2
Aggregate Demand in the
Closed Economy
 In the closed economy,
macroeconomic equilibrium occurs
where IS and LM curves intersect.
 When prices change, IS curve is not
affected.
 When prices change, real money
supply changes, shifting the LM
curve.
 We can trace out the aggregate
demand (AD) curve by seeing how Y
changes as P changes.
27-3
Derivation of Aggregate Demand
Curve: Closed Economy
i
P
LM2(P2)
LM1(P1)
LM0(P0) P2
P1
P0
i2
i1
i0
AD
IS
Y2 Y1 Y0
Y
Y2 Y 1 Y0
Y
27-4
Aggregate Demand in the
Closed Economy
 The more elastic IS or LM are, the
more elastic AD will be.
 If IS shifts right (left), AD shifts right
(left).
 An increase in the tax rate makes IS
and AD steeper.
 When LM shifts right (left), AD shifts
right (left).
27-5
Aggregate Supply in the
Closed Economy
 AS is determined by:
• level of technology,
• quantity of resources available,
• efficiency with which resources are used,
and
• level of employment of resources.
 In the short run, the first 3 are
assumed fixed.
 Employers hire workers up to the
point where wage equals the marginal
revenue product: W=P•MPPN.
27-6
Aggregate Production and the
Demand for Labor
W, MPPN
Y
Y1
Y0
Y2
W0
MRPN1
MRPN2MRPN0
IS
N2
N0
N1
N
Y2 Y1
N0
N
27-7
Aggregate Supply in the
Closed Economy
 Suppose W is fixed – this mean firms
can hire as much labor as they wish
at the going wage (labor supply is
perfectly elastic).
 If P increases, MRPN shifts
rightwards.
 This leads to a higher level of
employment and thus output.
 Therefore P and Y are directly related.
27-8
The Aggregate Supply
Curve With a Fixed Wage
P
AS
P1
P0
P2
Y2
Y0
Y1
Y
27-9
Aggregate Supply in the
Closed Economy
 However, labor supply is probably not
perfectly elastic – to induce a greater
quantity of labor supplied, wages
must rise.
 The resulting AS curve will be
steeper.
27-10
Variable Wages and the
Aggregate Supply Curve
W, MRP
MRP2
MRP0 MRP1
NS
W1
P
AS
P1
W0
P0
W2
P2
N2
N0
N1
Y2 Y0
Y1
Y
27-11
Aggregate Supply in the
Closed Economy
 In fact, the quantity of labor supplied
depends on the real wage.
 Once workers realize that P has risen
they will demand a higher wage.
 This means that an increase in P may
temporarily “fool” workers into
supplying a higher quantity labor (and
thus produce more output), but labor
supply will shift leftwards eventually;
Y returns to natural level of income.
27-12
Labor Market Adjustment
to Higher Prices
S'N
P
MRPN
MRP'N
SN
W2
W1
W0
Y
N0 N1
27-13
Equilibrium in the Closed
Economy
 Putting aggregate supply and
aggregate demand together allows us
to see equilibrium output and price
level.
 If for whatever reason AD increases,
there will be a temporary increase in
output and prices.
 Once workers realize P has increased,
they will decrease labor supply.
 This will shift AS leftwards, leaving us
with the original Y but a higher price
level.
27-14
Equilibrium in the Closed
Economy
ASSR1
P
ASLR
ASSR0
P
P12
P0
AD1
AD0
Y0 Y1
Y
27-15
Equilibrium in the Closed
Economy
 The short run AS curve is upwardsloping.
 The long run AS curve is a vertical
line.
27-16
Aggregate Demand in the
Open Economy Under
Fixed Rates
 When the economy is open, we must
also consider the BP curve when
deriving AD.
 If P increases:
• LM shifts leftwards.
• BP shifts leftwards.
• IS shifts leftwards.
 Ultimately, a new equilibrium will
occur at a lower level of Y.
27-17
Aggregate Demand in the Open
Economy Under Fixed Rates
LMP1
LMP0
i
P
BPP1
BPP0
i0
i1
P1
P0
ISP1 ISP0
Y1 Y0
Y
AD
Y1
Y0
Y
27-18
Aggregate Demand in the
Open Economy Under
Flexible Rates
 If P increases:
• LM shifts leftwards.
• BP shifts leftwards.
• IS shifts leftwards.
 An incipient surplus or deficit may
ensue, causing exchange rate
adjustment and further shifts of BP
and IS.
 Ultimately, a new equilibrium will
occur at a lower level of Y.
27-19
Effect of Exogenous
Shocks on AD Curve Under
Fixed and Flexible Rates
Fixed
Flexible
Δ in partner-country variable that increases homecountry exports
AD shifts
right
No effect
on AD
Δ in partner-country variable that alters short-term
capital flows in partner-country’s favor
AD shifts
left
AD shifts
right
Δ in home-country variable that reduces homecountry exports
AD shifts
left
No effect
on AD
Δ in home-country variable that stimulates shortterm capital inflows
AD shifts
right
AD shifts
left
Expansionary monetary policy
No effect
on AD
AD shifts
right
Expansionary fiscal policy
AD shifts
right
Little
effect on
AD
27-20
Monetary Policy in AS/AD
Framework: Flexible Rates
 Since monetary policy in the presence
of fixed rates has limited effect on
AD, we focus on a flexible rate
regime.
 Expansionary monetary policy shifts
AD rightwards, with higher Y and P.
 Eventually, workers realize P is higher
and decrease labor supply.
 This shifts AS leftwards.
 The economy return to the original
level of Y, but with higher P.
27-21
Monetary Policy in AS/AD
Framework: Flexible Rates
ASSR1
P
ASLR
ASSR0
P2
P1
P0
AD1
AD0
Y0 Y1
Y
27-22
Fiscal Policy in AS/AD
Framework: Fixed Rates
 Since fiscal policy in the presence of
flexible rates has limited effect on AD
(esp. if capital is relatively mobile),
we focus on a fixed rate regime.
 Expansionary fiscal policy shifts AD
rightwards, with higher Y and P.
 Eventually, workers realize P is higher
and decrease labor supply.
 This shifts AS leftwards.
 The economy return to the original
level of Y, but with higher P.
27-23
Fiscal Policy in AS/AD
Framework: Fixed Rates
ASSR1
P
ASLR
ASSR0
P2
P1
P0
AD1
AD0
Y0 Y1
Y
27-24
Economic Policy and
Supply Considerations
 Some policies can also affect AS.
 For example, suppose a tax cut not
only expands AD, but also causes AS
to shift to the right, as supply-side
economists predict?
 The tax cut will end up increasing Y,
but the ultimate effect on P is
ambiguous.
27-25
Economic Policy and Shifts
in the Long-Run AS Curve
ASLR
P
AS'LR
ASSR0
ASSR1
?
P0
?
AD1
AD0
Y0
Y1
Y
27-26
External Shocks: Increase
in Price of Imported Input
 What if a critical imported input (e.g.,
crude oil) increases in price?
 In a flexible exchange rate system,
this causes
• a depreciation of the home currency,
• an expansion of AD, and
• a leftward shift of short- and long-run AS.
 The result may be stagflation:
simultaneous decreases in income
coupled with rising prices.
27-27
Effect of a Price Shock of
an Imported Input
P
ASLR1
ASLR0
ASSR1
ASSR0
P1
P0
AD1
AD0
Y2 Y1Y0
Y
27-28
External Shocks: Foreign
Financial Shock
 What if a foreign financial shock
triggers an inflow of short-term
capital?
 In a flexible exchange rate system,
this causes
• an appreciation of the home currency,
• an contraction of AD, and
• lower income and prices.
 The economy could return to original
Y by expansionary monetary or fiscal
policy, or wait for the LR adjustment.
27-29
External Shocks: Foreign
Financial Shock
P
ASSR0
ASLR0
P0
P1
AD0
AD1
Y1 Y0
Y
27-30
External Shocks:
Technological Change
 What if technological change occurs?
 SR AS shifts rightwards, temporarily giving
us a new equilibrium with higher income and
lower prices (at P1 and Y1).
 But LR AS also shifts rightwards, perhaps to
the right of Y1.
 Now the economy is below its new natural
level, Y2.
 The economy will adjust by a further
rightward shift of SR AS, or expansionary
monetary or fiscal policy could be employed.
27-31
External Shocks:
Technological Change
P
ASLR1
ASLR0
ASSR0-W0
ASSR1-W0
ASSR1-W1
P0
P1
P2
AD0
AD1
Y0 Y1 Y2
Y
27-32