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Determinants of Aggregate Demand in an Open Economy Aggregate demand: The amount of a country’s goods and services demanded by households and firms throughout the world. D = C + I + G + CA • Consumption demand C = C(Yd) – The increase in consumption demand is less than the increase in the disposable income because part of the income increase is saved. • Investment demand I • Government demand G • Current account CA = EX – IM = CA(EP*/P,Yd) Copyright © 2003 Pearson Education, Inc. Slide 16-1 Determinants of Aggregate Demand in an Open Economy Real Exchange Rate q = EP*/P • Increase in q real depreciation increase in EX – Each unit of domestic output purchases fewer units of foreign output foreigners get a better deal on our output foreigners buy more of our exports volume of EX up • Increase in q can raise or lower IM and has an ambiguous effect on CA. Volume effect: we buy fewer imports when q increases Value effect: we pay more in real terms (in units of domestic product) for the imports we do buy when q increases We assume that the volume effect of a real exchange rate change outweighs the value effect: q up CA “improves”. Copyright © 2003 Pearson Education, Inc. Slide 16-2 Determinants of Aggregate Demand in an Open Economy Factors Determining the Current Account Copyright © 2003 Pearson Education, Inc. Slide 16-3 The Equation of Aggregate Demand Aggregate Demand as a Function of Output Aggregate demand, D Aggregate demand function, D(EP*/P, Y – T, I, G) 45° Output (real income), Y Copyright © 2003 Pearson Education, Inc. Slide 16-4 Output market equilibrium in the short-run: The Keynesian Cross. Real output, Y, equals aggregate demand for domestic output: Y = D(EP*/P, Y – T, I, G) Aggregate demand, D Aggregate demand = aggregate output, D = Y Aggregate demand D1 1 3 Y1 Y3 2 45° Y2 Copyright © 2003 Pearson Education, Inc. Output, Y Slide 16-5 Output Market Equilibrium in the Short Run: The DD Schedule Output, the Exchange Rate, and Output Market Equilibrium • With P and P* fixed, depreciation makes foreign goods and services more expensive relative to domestic goods and services. – q up (real depreciation) upward shift in aggregate demand (D) expansion of output (Y). – q down downward shift in D Y down Copyright © 2003 Pearson Education, Inc. Slide 16-6 Output Market Equilibrium in the Short Run: The DD Schedule Output Effect of a Currency Depreciation with Fixed Output Prices Aggregate demand, D D=Y Currency depreciates 2 Aggregate demand (E2) Aggregate demand (E1) 1 45° Y1 Copyright © 2003 Pearson Education, Inc. Y2 Output, Y Slide 16-7 The DD Schedule: combinations of output and the exchange rate where output market is in short-run equilibrium (Y = D). DD slopes upward -- a rise in the exchange rate (depreciation) Y increases. Aggregate demand, D D=Y Aggregate demand (E2) Aggregate demand (E1) Exchange rate, E Y1 Copyright © 2003 Pearson Education, Inc. Output, Y DD E2 E1 Y2 2 1 Y1 Y2 Output, Y Slide 16-8 Output Market Equilibrium in the Short Run: The DD Schedule Factors that Shift the DD Schedule. • • • • • • • Increases in Government purchases expansion DD shifts out Taxes contraction DD shifts in Investment expansion DD shifts out Domestic price levels contraction in CA DD shifts in Foreign price levels expansion in CA DD shifts out Domestic consumption expansion DD shifts out Demand shift between foreign and domestic goods A disturbance that raises (lowers) aggregate demand for domestic output shifts the DD schedule to the right (left). Copyright © 2003 Pearson Education, Inc. Slide 16-9 Output Market Equilibrium in the Short Run: The DD Schedule Government Demand and the Position of the DD Schedule Aggregate demand, D Government spending rises D=Y D(E0P*/P, Y – T, I, G2) Aggregate demand curves D(E0P*/P, Y – T, I, G1) Y1 Exchange rate, E Y2 Output, Y DD1 DD2 E0 Copyright © 2003 Pearson Education, Inc. 1 2 Y1 Y2 Output, Y Slide 16-10 AA Schedule: combinations of exchange rate and output that are consistent with asset market equilibrium (the domestic money market and the foreign exchange market). Foreign exchange market equilibrium (interest rate parity): R = R* + (Ee – E)/E where: Ee is the expected future exchange rate R is the interest rate on domestic currency deposits R* is the interest rate on foreign currency deposits Money Market equilibrium Ms/P = L(R, Y) Copyright © 2003 Pearson Education, Inc. Slide 16-11 Asset Market Equilibrium in the Short Run: The AA Schedule Output and the Exchange Rate in Asset Market Equilibrium: Y up Ld up R up E down (currency appreciates) Exchange Rate, E Foreign exchange market E1 E2 0 Money market 1' 2' R1 R2 Domestic-currency return on foreigncurrency deposits Domestic interest rate, R L(R, Y1) L(R, Y2) MS P Output rises 1 2 Real money supply Real domestic money holdings Copyright © 2003 Pearson Education, Inc. Slide 16-12 Asset Market Equilibrium in the Short Run: The AA Schedule The AA Schedule: Y up E down (currency appreciation) Exchange Rate, E 1 E1 2 E2 AA Y1 Copyright © 2003 Pearson Education, Inc. Y2 Output, Y Slide 16-13 Asset Market Equilibrium in the Short Run: The AA Schedule Factors that Shift the AA Schedule For given Y Domestic money supply: Ms up R down E up Domestic price level: P up Ms/P down R up E down Expected future exchange rate: Ee up E up Foreign interest rate: R* up E up (depreciation) Real money demand: Ld up R up E down (appreciation) Copyright © 2003 Pearson Education, Inc. Slide 16-14 Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together Short-Run Equilibrium: The Intersection of DD and AA Exchange Rate, E DD 1 E1 Y1 Copyright © 2003 Pearson Education, Inc. Output, Y Slide 16-15 Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together How the Economy Reaches Its Short-Run Equilibrium: asset markets clear instantly always on AA curve $ cheap at 2 Expected $ appreciation rush to US assets $ appreciation NOW Exchange Rate, E E2 E3 DD 2 3 1 E1 AA Y1 Copyright © 2003 Pearson Education, Inc. Output, Y Slide 16-16 Temporary Changes in Monetary and Fiscal Policy Two types of government policy: • Monetary policy: works through changes in money supply. • Fiscal policy: works through changes in government spending (G) or taxes (T). – Temporary policy shifts are those that the public expects to be reversed in the near future and do not affect the long-run expected exchange rate. – Also, assume policy shifts do not influence the foreign interest rate and the foreign price level. Copyright © 2003 Pearson Education, Inc. Slide 16-17 Temporary Change in Monetary Policy Temporary Increase in the Money Supply: R down E up (depreciation) at each value of Y AA shifts up Exchange Rate, E DD 2 E2 1 E1 AA2 AA1 Y1 Copyright © 2003 Pearson Education, Inc. Y2 Output, Y Slide 16-18 Temporary Change in Fiscal Policy Temporary Fiscal Expansion: G up Y increases at each value of E DD shifts outward Exchange Rate, E DD1 DD2 1 E1 2 E2 AA Y1 Copyright © 2003 Pearson Education, Inc. Y2 Output, Y Slide 16-19 Temporary Changes in Monetary and Fiscal Policy Maintaining Full Employment After a Temporary Fall in World Demand for Domestic Products: Prop up demand with fiscal or monetary stimulus (M up AA shifts up; G up DD shifts out) Exchange Rate, E DD2 DD1 E3 3 2 E2 AA2 1 E1 AA1 Y2 Copyright © 2003 Pearson Education, Inc. Yf Output, Y Slide 16-20 Temporary Changes in Monetary and Fiscal Policy Policies to Maintain Full Employment After Money-Demand Up (Money “shortage” recession). So Increase G or Ms Exchange Rate, E DD1 DD2 E1 1 2 E2 AA1 3 E3 AA2 Y2 Copyright © 2003 Pearson Education, Inc. Yf Output, Y Slide 16-21 Problems of Policy Formulation • Inflation bias – High inflation with no average gain in output that results from governments’ policies to prevent recession • • • • • Identifying the sources of economic changes Identifying the durations of economic changes The impact of fiscal policy on the government budget Time lags in implementing policies Policy impacts on current account balance Copyright © 2003 Pearson Education, Inc. Slide 16-22 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. • This affects expectations about future exchange rates. A Permanent Increase in the Money Supply expected future exchange rate (Ee)rises proportionally upward shift in AA schedule is greater than that caused by an equal, but transitory, increase need expected appreciation in the future to offset lower interest rate, R OVERSHOOTING Copyright © 2003 Pearson Education, Inc. Slide 16-23 Permanent Shifts in Monetary and Fiscal Policy Short-Run Effects of a Permanent Increase in the Money Supply (E3 is newly expected long-run exchange rate) Exchange Rate, E DD1 2 E2 3 1 E1 AA2 AA1 Yf Copyright © 2003 Pearson Education, Inc. Y2 Output, Y Slide 16-24 Permanent Shifts in Monetary and Fiscal Policy Long-Run Adjustment to a Permanent Increase in Money Supply (As P rises, CA worsens (DD in) and R rises (AA down) Exchange Rate, E DD2 DD1 2 E2 E3 E1 3 AA2 1 AA3 AA1 Yf Copyright © 2003 Pearson Education, Inc. Y2 Output, Y Slide 16-25 Permanent Fiscal Expansion Expected Appreciation Shifts AA Down Immediately No Change in Output, Even in Short-Run Complete Crowding Out Exchange Rate, E DD1 DD2 E1 1 3 AA1 2 E2 AA2 Yf Copyright © 2003 Pearson Education, Inc. Output, Y Slide 16-26 Macroeconomic Policies and the Current Account XX schedule shows combinations of the exchange rate and output at which the CA balance stays at some desired level. • XX slopes upward: Y up Im up CA worsens unless currency depreciates. – E must increase to keep CA where it was when Y up. • XX is flatter than DD: – When currency depreciates (E up), CA improves along DD – that’s why Y increases when currency depreciates. – To keep CA from changing, E need only increase enough to offset increased imports attributable to output expansion. Copyright © 2003 Pearson Education, Inc. Slide 16-27 Monetary Expansion AA shifts up Depreciation CA “improves” (Point 2) Fiscal Expansion DD shifts out Appreciation CA “worsens” (Point 3 for temporary fiscal expansion; Point 4 for permanent fiscal expansion). Exchange Rate, E DD XX 2 1 E1 3 4 Yf Copyright © 2003 Pearson Education, Inc. Output, Y Slide 16-28 Gradual Trade Flow Adjustment and Current Account Dynamics The J-Curve: if imports and exports adjust gradually to real exchange rate changes, the CA may follow a Jcurve pattern after a real currency depreciation, first worsening and then improving. – Currency depreciation may have a contractionary initial effect on output – exchange rate overshooting will be amplified. • The J-Curve describes the time lag with which a real currency depreciation improves the CA. Copyright © 2003 Pearson Education, Inc. Slide 16-29 Gradual Trade Flow Adjustment and Current Account Dynamics The J-Curve Current account (in domestic output units) Long-run effect of real depreciation on the current account 1 3 2 Time Real depreciation takes place and J-curve begins Copyright © 2003 Pearson Education, Inc. End of J-curve Slide 16-30 Gradual Trade Flow Adjustment and Current Account Dynamics Exchange Rate Pass-Through and Inflation • The CA in the DD-AA model has assumed that nominal exchange rate changes cause proportional changes in the real exchange rates in the short run. • Degree of Pass-through – It is the percentage by which import prices rise when the home currency depreciates by 1%. – In the DD-AA model, the degree of pass-through is 1. – Exchange rate pass-through can be incomplete because of international market segmentation. – Currency movements have less-than-proportional effects on the relative prices determining trade volumes. Copyright © 2003 Pearson Education, Inc. Slide 16-31 Summary The aggregate demand for an open economy’s output consists of four components: consumption demand, investment demand, government demand, and the current account. Output is determined in the short run by the equality of aggregate demand and aggregate supply. The economy’s short-run equilibrium occurs at the exchange rate and output level. Copyright © 2003 Pearson Education, Inc. Slide 16-32 Summary A temporary increase in the money supply causes a depreciation of the currency and a rise in output. Permanent shifts in the money supply cause sharper exchange rate movements and therefore have stronger short-run effects on output than transitory shifts. If exports and imports adjust gradually to real exchange rate changes, the current account may follow a J-curve pattern after a real currency depreciation, first worsening and then improving. Copyright © 2003 Pearson Education, Inc. Slide 16-33 Appendix I: The IS-LM Model and the DD-AA Model Figure 16AI-1: Short-Run Equilibrium in the IS-LM Model Interest rate, R LM 1 R1 Y1 Copyright © 2003 Pearson Education, Inc. Output, Y Slide 16-34 Appendix I: The IS-LM Model and the DD-AA Model Figure 16AI-2: Effects of Permanent and Temporary Increases in the Money Supply in the IS-LM Model 1 LM Expected domestic-currency return on foreign-currency deposits Interest rate, R 1´ 2´ E2 E3 Exchange rate, E 1 R1 R2 2 3 R3 3´ LM2 E1 Y1 Y3 Y2 Output, Y ( increasing) Copyright © 2003 Pearson Education, Inc. Slide 16-35 Appendix I: The IS-LM Model and the DD-AA Model Figure 16AI-3: Effects of Permanent and Temporary Fiscal Expansions in the IS-LM Model Expected domestic-currency return on foreign-currency deposits 1´ E1 Exchange rate, E Interest rate, R R2 2´ 3´ E2 LM R1 E3 2 1 Yf Y2 Output, Y ( increasing) Copyright © 2003 Pearson Education, Inc. Slide 16-36 Appendix II: Intertemporal Trade and Consumption Demand Figure 16AII-1: Change in Output and Saving Future consumption D2F D1 F = Q1 Intertemporal budget constraints 2 1 F 2´ Indifference curves D1P = Q1P Copyright © 2003 Pearson Education, Inc. D2P Q2P Present consumption Slide 16-37 Appendix III: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities Table 16AIII-1: Estimated Price Elasticities for International Trade in Manufactured Goods Copyright © 2003 Pearson Education, Inc. Slide 16-38