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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