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CHAPTER
9
International Adjustment:
Aggregate Demand and Supply in an Open
Economy
Learning objectives



Understand that national economies are linked through
trade flows.
Understand that the real exchange rate is a measure of
the price of Canadian goods relative to the price of
foreign goods measured in one country.
Understand that an increase in real exchange rate,
which is called an improvement in the terms of trade,
will lead to an increase in net exports, through a
decrease in imports and an increase in exports.
PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa
Copyright 2005 © McGraw-Hill Ryerson Ltd.
CHAPTER
9
International Adjustment:
Aggregate Demand and Supply in an Open
Economy
Learning objectives (cont’d)


Understand that, in the long run, a monetary expansion
will depreciate the nominal exchange rate and raise the
domestic price level, leaving the domestic exchange
rate unaltered.
Understand that the monetary approach to the balance
of payments emphasizes the connection between the
changing supply and the level of the balance of
payments.
PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa
Copyright 2005 © McGraw-Hill Ryerson Ltd.
AD, AS, and net exports
ePf
R
P
(1)
o e: nominal exchange rate
o Pf: nominal price of foreign goods, measured in
foreign currency.
o P: Canadian dollar price of Canadian goods.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 9: International Adjustment
o Real exchange rate (or terms of trade): The
ratio of foreign prices to Canadian prices,
measured in a common currency.
Slide 3
AD, AS, and net exports
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 9: International Adjustment
o Open Economy Aggregate Demand Curve:
The aggregate demand curve that takes
into account changes in the real exchange
rate.
Slide 4
AD, AS, and net exports
Price level
Figure 9-1: The Open Economy AD Curve
In an open economy, an additional
reason for the AD curve to slope
downward is that, for a given foreign
price level and nominal exchange
rate, a decrease in the Canadian
Price Level improves the terms of
trade and increases net exports.
For a given Canadian price level, a
depreciation in the nominal exchange
rate or an increase in the foreign
price level will increase the terms of
trade and shift the AD curve outward
AD' M , A1, R1 
ADM , A1, R0 

Copyright 2005 © McGraw-Hill Ryerson Ltd.

Y
Slide 5
AD, AS, and net exports
S - I = NX
Copyright 2005 © McGraw-Hill Ryerson Ltd.
(2)
Chapter 9: International Adjustment
o External Equilibrium:
Slide 6
Appreciation and Depreciation: Is it Up or Down?
BOX
9-1
When the nominal exchange rate
is expressed in Canadian dollars:
When the nominal exchange rate
is expressed in US dollars:

Copyright 2005 © McGraw-Hill Ryerson Ltd.
ePf
R
P
EP
R
Pf
Slide 7
AD, AS, and net exports
Real Exchange Rate
Supply
Demand
(Net
foreign
lending)
(Net exports)
R0
Copyright 2005 © McGraw-Hill Ryerson Ltd.
The
Canadian
dollarsfrom
comes
The supply
demandoffor
dollars comes
the
from
foreign
investment
thatSupply
is
need net
to pay
for our
net exports.
supplied
to the
exchange
to buy
and demand
determine
themarket
equilibrium
foreign
assets,rate,
suchR.as foreign bonds.
real
exchange
$ CDA
Q
Chapter 9: International Adjustment
Figure 9-2: Supply and Demand for Canadian Dollars
Slide 8
AD, AS, and net exports
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 9: International Adjustment
o Effects of expansionary Monetary Policy: An
increase in the nominal money supply shifts the
AD curve outward to AD’ and the Canadian price
level increase to P’. In the short run, for a given
nominal exchange rate and a given foreign price
level, the terms of trade worsen. This is shown as
a new short run real exchange rate of R’ in Figure
9-3(b). At the new long run equilibrium, the price
level in the Canadian economy is P1, which is
consistent with the quantity theory of money. This
price level is also consistent with PPP, as the real
exchange rate and the level of net exports are the
same as they were prior to the monetary
expansion.
Slide 9
AD, AS, and net exports
Figure 9-3: Open Economy Adjustment to a Money Shock
P
R
E1
Real Exchange Rate
P1
P’
P0
E
Y*
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Y
R0
E
R’
$ CDA
Slide 10
AD, AS, and net exports
Figure 9-4: The Real Exchange Rate and Net Exports
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 11
The J-Curve
BOX
9-2
The trade balance in terms of
domestic goods:
ePf
NX  X 
Q
P
X: Foreign demand for our goods or exports.
Q: Our import quantity.
ePf /P: Value of our imports in term of domestic goods.

Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 12
BOX
Fixed Exchange rates and Devaluation
9-3
o Prior to the early 70s most countries, Canada included were
on a fixed exchange rate regime.
o If there was a balance of payment deficit position = Excess
supply of Canadian dollars (or excess demand of foreign
currency).
o The Bank of Canada would then buy Canadian dollars with
foreign currency.
o This situation cannot be maintained indefinitely.
o A country must adjust by lowering the price level =
recession = higher unemployment.
o A less painful strategy would be to devalue the domestic
currency leading to an improvement of the terms of trade by
increasing exports and decreasing imports and thus
correcting the trade imbalance.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 13
The Monetary Approach to the BOP
o Simple version: Money contraction => rise in
interest rates => reduces pending => reduces
incomes => reduces imports.
o Sophisticated version: A sale of foreign
exchange => reduces the stock of high
powered money => reduces the money stock.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 9: International Adjustment
o Suggestion: External balance problems
are monetary in nature and that balance of
payment deficits are a reflection of
excessive money supply.
Slide 14
The Monetary Approach to the BOP
o A deficit country that is selling foreign
exchange may offset the resulting reduction in
the money supply by purchasing bonds.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 9: International Adjustment
o Sterilization: To offset (or sterilize) the
impact of monetary intervention on the
foreign exchange market, the central bank
will engage in open market operations.
Slide 15
The Monetary Approach to the BOP
NFA  H  DC
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 9: International Adjustment
o Monetary Approach: The emphasis on monetary
considerations in the interpretation of external
balance problems.
o This approach has been used extensively by the
IMF in its analysis and design of economic
policies for countries with balance of payment
trouble.
(3)
Slide 16
Exchange Rates and Interdependence
o Through monetary policy
o Through prices
o Through fiscal policy
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 9: International Adjustment
o Spillover (interdependence) effects:
Occur when policy changes or
supply/demand shocks in one
country affect output in another.
Slide 17
Chapter Summary
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 9: International Adjustment
• The real exchange rate measures the relative
price of domestic goods to foreign goods.
• An increase in the real exchange rate will lead
to an increase in net exports.
• In the long run, a monetary expansion
increases the price level and depreciates the
nominal exchange rate.
• The monetary approach to the balance of
payments draws attention to the fact that a
payment deficit is always a reflection of a
monetary disequilibrium and is always selfcorrecting.
Slide 18
Chapter Summary (cont’d)
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 9: International Adjustment
• Even under flexible exchange rates,
economies are closely tied to one another. A
monetary expansion at home will lead to
unemployment and disinflation abroad.
Slide 19
The End
Chapter 9: International Adjustment
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 20