Download Output and the Exchange Rate in the Short Run

Output and the Exchange Rate
in the Short Run
Introduction
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How can we analyze the short run of an open
economy?
What are the impacts on a country’s imports
and exports from changes in the real
exchange rate?
How much effect do changes in foreign trade
have on growth rate of GDP?
What is the importance of the real exchange
rate in an open economy?
Aggregate Demand
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Relationship between total quantity
demanded of goods and services in all sectors
of the economy and the price level, holding
all else constant
Total output of goods and services measured
by real GDP – horizontal axis
Price level measured by GDP price deflator –
vertical axis
AD curve slopes downward – as price level
declines, quantity of goods demanded
increases
Aggregate Demand
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Does not behave in the same manner
as an ordinary demand curve
Price of product falls

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Consumer’s real income rises – increases
amount consumed for normal good
(income effect)
Lower price induces consumers to
purchase more of product b/c cheaper
(substitution effect)
Aggregate Demand
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Neither the income or substitution
effect are relevant to overall price level
If aggregate price level falls
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Prices consumers pay are falling
Prices people receive as wages, rents, etc.
are also falling
No change in demand
Aggregate Demand
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Price level is measure of prices in
general, not a particular price
As price level falls there is no
substitution effect b/c prices in general
are falling, not the price of a particular
good.
Aggregate Demand
Why is AD negatively sloped?
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1.
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As price level changes, value of
individual’s real wealth changes – wealth
effect
Increase in price level:
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Reduces value of accumulated financial assets
Consumers reduce consumption of goods
Aggregate quantity demanded changes
Aggregate Demand
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Why is AD negatively sloped? (cont.)
2.
Rise in price level increases interest rates –
interest rate effect
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3.
Lower business investment
Lower consumer spending on housing and cars
Aggregate quantity demanded falls
Price level changes impact country’s total
exports and imports – international substitution
effect
Aggregate Demand
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Why is AD negatively sloped? (cont.)
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Price level increase
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Price of domestic goods rises relative to foreign
goods
Foreign demand (exports) for domestic goods
decreases
Domestic demand (imports) for foreign goods
increases
Aggregate quantity demanded declines
Aggregate Demand
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All three effects lead to decreases in
aggregate quantity demanded (output
of goods and services) as price level
increases (all else equal)
The opposite is also true
Inverse relationship is shown as
movement along aggregate demand
curve
Aggregate Demand Curve
Changes in Aggregate Demand
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Changing one of the variables held
constant along the AD curve will cause
a shift in the curve
Increases (decreases) in AD will shift
the curve to the right (left)
New AD curve shows at any given price
level, society wants to buy more (less)
goods and services
Changes in Aggregate Demand
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Expenditure approach to calculating
GDP
Look at the four sectors of an open
economy that buy real goods/services
GDP  C  I  G  ( X  I )

Changes in any above factors, shifts AD
Changes in Aggregate Demand
Changes in Aggregate Demand
Consumption (C)
I.
A.
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Consumer wealth
As consumer wealth increases
(decreases), level of consumption
increases (decreases)
Increase (decreases) in consumption
shifts AD curve to right (left)
Changes in Aggregate Demand
Consumer expectations
B.
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More confident consumers are about the
future, more likely to consume today
Increased confidence increases AD (curve
shifts right)
Reverse is also true
Changes in Aggregate Demand
Degree of consumer indebtedness
C.
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High level of indebtedness from past
consumption financed by borrowing
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Must pay off existing dept
May need to reduce current consumption
Consumer spending falls
AD curve shifts left
Reverse is also true
Changes in Aggregate Demand
Taxes
D.
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Higher taxes (or lower transfer payments)
reduce society’s after tax income
Lower income leads to lower
consumption spending
AD curve shifts left
Reverse is also true
Changes in Aggregate Demand
Investment spending
II.
Higher interest rates
A.
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Decreases business investment and public investment
in housing
Aggregate demand decreases (shifts left)
Opposite is also true
Expectations of future economic conditions
B.
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Current economic conditions affect expectations of
future in same direction thereby affecting investment
spending
Changes in Aggregate Demand
Investment spending (cont.)
II.
Government changes in business
taxation
C.
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Increasing (decreasing) business
taxes raise (lower) investment
spending and aggregate demand
Changes in Aggregate Demand
Government Spending
III.
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Increasing in government spending on
goods/services, increases aggregate
demand
Opposite is also true
Government spending at federal, sate or
local level
Changes in Aggregate Demand
Exports and Imports
IV.
Exports sensitive to changes in income
of foreign countries
A.
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Increases in foreign incomes increase
exports which increases aggregate demand
(and vice versa)
Faster foreign economic growth leads to
greater changes in US aggregate demand
Slower foreign growth (recessions)
negatively impacts US aggregate demand
Changes in Aggregate Demand
Exports and Imports (cont.)
IV.
Movements in real exchange rate
As dollar depreciates
B.
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Foreign currency buys more US goods –
increases exports
US currency buys fewer foreign goods –
decreases imports
Aggregate demand increases
Opposite is also true
Changes in Aggregate Demand
Aggregate Supply
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Relationship between the total quantity
of goods/services an economy produces
at various price levels, holding all other
determinant of production unchanged.
Slopes upward to the right
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As price level rises, quantity of goods and
services economy produces increases
Aggregate Supply
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Why is AS positively sloped?
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Represents entire economy’s total
production
Higher price level is necessary to bring a
higher level of total production
Assume short run labor force, capital
stock, stock of natural resources, and
level of technology are constant
Aggregate Supply
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Why is AS positively sloped? (cont.)
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Related to both rising demand for output and
rising unit costs as economy moves closer to full
employment
As output expands, prices of some inputs rise
before economy reaches full employment leading
to rising unit costs
As some prices rise while others are constant,
price level on average increases before reaching
full employment
Aggregate Supply
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Why is AS positively sloped? (cont.)
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Most important price in economy is price of labor
Hiring more labor decreases K/L ratio
MPL decreases and wage rate increases
Leads to rising production costs
Rising price level means higher prices are
necessary to increase total output – upward
sloping AS curve
Aggregate Supply
Aggregate Supply
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Change in aggregate supply means per unit
production costs are rising (falling) for some
reason unrelated to an increase in production
(output)
Increases in AS will shift the curve to right
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At any given price level, firms are willing and able
to produce more goods/services
Firms can produce same level of output at lower
unit costs – unit costs have declined
Changes in Aggregate Supply
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Decreases in AS will shift the curve to
the left
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Unit costs of production have increased
Two types of changes or shifts in AS
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Changes due to changes in potential real
GDP
Changes in major determinants of AS curve
held constant along the curve
Changes in Aggregate Supply
Changes in Aggregate Supply
Changes in potential real GDP
I.
Factors of production
A.
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Productivity of factors of production
B.
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As factors of production (land, labor, capital,
entrepreneurial ability) increase over time,
AS curve will shift right
Increases in productivity reduce unit costs
and shift AS curve to right
Synonymous with country’s long run
economic growth
Changes in Aggregate Supply
Determinants of aggregate supply
II.
Input prices
A.
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Increases in input prices increase costs of
production decreasing AS
EX: increases in wages, oil shock
Exchange rate shock
B.
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Large change in real value of a country’s
currency in short period of time
Change change firm’s costs of production
changing aggregate supply
Changes in Aggregate Supply
Determinants of aggregate supply
II.
Changes in business taxes
C.
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Increases in overall business taxes increases
costs of production decreasing AS and vice
versa
EX: sales taxes, excise taxes, payroll taxes
Public’s inflationary expectations
D.
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Perceived increases in future inflation cause
adjustments in economic action today.
Changes in Aggregate Supply
D.
Public’s inflationary expectations (cont.)
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Producers may attempt to increase prices
today to stay ahead of anticipated inflation
Workers attempt to receive larger salary
increases today to protect real wages and
standards of living
Aggregate supply curve will decrease (left
shift)
Changes in Aggregate Supply
Aggregate Equilibrium
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Intersection of AS and AD determines
the open economy’s equilibrium
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Equilibrium level of real output (production
and spending) for economy at Ye
Equilibrium price level for the economy at
Pe
Shifts in AS or AD will change equilibrium
level of output and price level
Aggregate Equilibrium
Aggregate Equilibrium
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Note that changes in exchange rate
shift both AD and AS curves
Changes in exchange rate can affect an
open economy’s equilibrium level of
output and price level
Not only are trade flows (exports and
imports) affected, but there are
noticeable impacts on entire economy
Determinants of Current Account
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Changes in AD and AS influence output
We will focus on one component of aggregate
demand and supply – the current account
How does a change in the current account
(exports minus imports) impacts the
equilibrium level of output
Changes in other determinants of AD and AS
will be ignored
Changes in Current Account
Exports
I.
Level of income in foreign countries, Yf
A.
Exports change with changes in foreign
incomes
Size of change determined by two factors
Size of change in foreign income
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1.
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Larger income changes have larger effects on
exports
Changes in foreign income that affect a country’s
exports are weighted averages of changes in
income among the countries trading partners
Changes in Current Account
Exports (cont.)
I.
Income elasticity of demand for the
country’s exports
2.

Percentage change in a country’s exports
relative to the percentage change in foreign
income
(Yf )
% in X

% in Y f
Changes in Current Account
Exports (cont.)
I.
Income elasticity of demand for the
country’s exports
2.
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Elasticity is a positive number
As foreign incomes increase (decrease), a
country’s exports increase (decrease)
Size of country’s foreign income elasticity
depends on product mix of a country’s
exports
Changes in Current Account
Exports (cont.)
I.
Income elasticity of demand for the
country’s exports
2.
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If a country exports a high percentage of
goods with high income elasticities of
demand, they will tend to have a higher
foreign income elasticity and vice versa
US close to 1, Germany and Japan greater
than 1, Chile, South Africa less than 1
Changes in Current Account
Exports (cont.)
I.
Real exchange rate (RXR)
As the real value of country’s currency
appreciates (depreciates, level of a
country’s exports declines (increases)
Size of effect depends on
B.
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Size of change in real exchange rate
1.
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The larger the change in RXR, the larger the effect
on exports
Changes in Current Account
Exports (cont.)
I.
Real exchange rate (RXR)
B.
2.
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Price elasticity of demand for exports
Sensitivity of a country’s exports to changes
in the real exchange rate
Sensitivity of a country’s exports is inversely
related to changes in real exchange rate
( RXR)
% in X

% in RXR
Changes in Current Account
Imports
II.
Level of domestic income (Yd)
A.
As domestic income rises, level of imports
rises
Size of effect depends on two factors
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
1.
2.
Size of change in domestic income
Income elasticity of demand for imports
(Yd )
% in M

% in Yd
Changes in Current Account
Imports
II.
Level of domestic income (Yd)
A.
Income elasticity of demand for imports
(cont.)
2.
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Income elasticity is positive – increases in
domestic income cause an increase in imports
May be equal to, greater than or less than 1
Real Exchange rate
3.
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As currency appreciates, imports increase
Changes in Current Account
II.
Imports
Real Exchange rate (cont.)
3.
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1.
2.
Magnitude of effect depends on two factors
Size of change in real exchange rate – smaller
changes have smaller effects
Price elasticity of demand for imports – percent
change in imports relative to percent change in
real exchange rate – direct relationship
( PMR)
% in M

% in RXR
Changes in Current Account
Effects on Open Economy
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AD is link between current account
balance and output
Since real exchange rates effect current
account, we can link them to changes in
domestic output
Effects on Open Economy
Exchange Rate Appreciation
I.
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Equilibrium exchange rate equates inflows and
outflows of foreign exchange at XRe
Assume rate is associate with purchasing
power parity (PPP)
Initial level of AD is also determined
Assume no capital flows between countries,
foreign trade is balanced at FXe, and economy
has equilibrium output of Ye
Effects on Open Economy
Exchange Rate Appreciation
I.
Assume real exchange rate changes –
currency appreciates to XR1
A.
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Assume caused by rightward shift of supply
of foreign exchange
Exports would fall and imports would rise
resulting in a current account deficit
Equal to difference between M and X in
figure 15.6 (a)
Effects on Open Economy
Effects on Open Economy
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Effects of current account deficit on real
economy
1.
Domestic economy’s AD will decrease as exports
fall and imports rise
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2.
AD shifts to left (15.6 b)
Equilibrium level of output (real GDP) falls
Price level falls as AD decreases
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Price of imports falls
Price of US produced goods that compete with imports
may fall
Effects on Open Economy
Effects on Open Economy
Exchange Rate Depreciation
II.
Demand for foreign exchange increases
A.
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Assuming no capital flows, we are in balanced trade
Assume PPP exchange rate
As exchange rate depreciates, current account
surplus would occur (M’ to X’)
Exports increase as price of domestic goods falls
Imports decrease and domestic price of imported
goods increases
Effects on Open Economy
Effects on Open Economy
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Effects of current account surplus on
economy
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Economy’s aggregate demand increase as
exports increase and imports decrease
Domestic real GDP increases as total
output increases
Country’s price level rises
Effects on Open Economy
Effects on Open Economy
Exchange Rate Shocks
III.
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Assume a 75% depreciation of a country’s
currency in one week
Demand for foreign exchange has increased
and supply has decreased
Exchange rate goes from XRe to XR’’
Could have been capital flight out of country
due to domestic crisis or due to exchange rate
being fixed at inappropriate level for long
period of time
Effects on Open Economy
Effects on Open Economy
Exchange Rate Shocks (cont.)
III.
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If depreciation is large, effects on AS can be
very large as well
For an open economy, depreciation causes a
large short-run increases in costs of production
AS shifts left decreasing output significantly
leading to recession
Price level increases significantly
Common for developing countries
Effects on Open Economy
Effects on Composition of Output
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
How does the composition of output
change in the long run due to changes
in exchange rate?
Distinction between
1.
2.
Tradeable goods – products commonly
sold in international markets
Non-tradeable goods – goods for which
selling between countries is too costly
Effects on Composition of Output

Assume currency appreciates


Open economy’s equilibrium output and
price level change
Overall production of tradeable goods falls
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
Exports decline and imports rise
Decline in price of tradeable goods makes
non-tradeable goods relatively more
expensive
Effects on Composition of Output
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Resources will flow to industry with higher
prices – non-tradable industry
If operating at full employment, resources
flow from sector that is declining to sector
that is expanding
Positive effect on economy’s non-tradable
goods sector
Occurred in US in early 1980’s as economy
shifted production away from tradeable goods
to non-tradeable goods
Effects on Composition of Output
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Opposite occurs when country’s currency
depreciates
Prices in tradeable goods sector increase and
output of tradeable goods increases
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Exports increase and imports fall
Resources flow from production of nontradeable goods to production of tradeable
goods
Changes in real exchange rate can have
critical impact on the mix of production in an
economy