Download Chapter 17 - Faculty of Business and Economics Courses

C h a p t e r
1 7
Output and the
Exchange Rate
in the Short Run
To accompany
International Economics, 3e by Sawyer/Sprinkle
PowerPoint slides created by Jeff Heyl
Copyright © 2009 Pearson Education, Inc.
Publishing as Prentice Hall
CHAPTER ORGANIZATION
• Introduction
• Aggregate Demand and Aggregate Supply:
•
•
•
•
A Review
Determinants of the Current Account
Exchange-Rate Changes and Equilibrium
Output in an Open Economy
Changes in the Exchange Rate and the
Composition of Output
Summary
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17 – 2
INTRODUCTION
• 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?
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17 – 3
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Aggregate Demand
• Aggregate demand is the relationship between
•
•
total quantity demanded of goods and services in
all sectors of the economy and the price level,
holding all else constant
The axis are total output of goods and services
measured by real GDP and the price level
measured by GDP price deflator
The aggregate demand curve slopes downward to
the right
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17 – 4
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
Figure 17.1
The Aggregate Demand Curve
Price Level
(P)
P1
B
A
P0
Aggregate
Demand (AD)
Y1
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Y0 Real GDP (Y)
17 – 5
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• The aggregate demand curve does not behave in
•
•
•
the same manner as an ordinary demand curve
If the price of product falls, the consumer’s real
income rises increasing the amount consumed for
a normal good (income effect)
The lower price induces consumers to purchase
more of product because it’s cheaper (substitution
effect)
Neither the income or substitution effect are
relevant to overall price level
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17 – 6
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• If the aggregate price level falls, prices
•
•
•
consumers pay are falling and prices people
receive as wages, rents, etc. are falling
No change in demand as the price level falls
The price level is a measure of prices in general,
not a particular price
As price levels falls there is no substitution effect
because prices in general are falling, not the price
of a particular good
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17 – 7
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• This means the aggregate demand curve is
•
•
•
negatively sloped for a different reason
When the price level changes, the value of
people’s wealth changes, the wealth effect
An increase in the price level reduces the value of
accumulated financial assets and induces people to
reduce their consumption of goods and services
As the price level changes, real wealth changes
and the aggregate quantity demanded changes
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17 – 8
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• As the price level rises, interest rates increase, the
•
•
interest rate effect
Higher interest rates curtail business investment
and consumer spending on items such as housing
and cars
As the price level increases, aggregate quantity
demanded falls, and vice versa
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17 – 9
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• As the price level changes, it impacts a country’s
•
•
•
total exports and imports, the international
substitution effect
As the price level increases, the price of
domestically produced goods rises relative to
foreign produced goods
Foreign demand for domestically produced goods
declines and domestic demand for imported goods
increases
An increase in price level increases a country’s
imports
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17 – 10
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Changes in Aggregate Demand
• Changes in the determinants of the aggregate
•
•
demand will cause the curve to shift
The new AD curve shows that at any given price
level, society wants to buy more (less) goods and
services
To analyze the shifts we can use the expenditure
approach to calculating GDP
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AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
Figure 17.2
Changes in Aggregate Demand
Price Level
(P)
AD’
AD”
AD
Real GDP (Y)
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17 – 12
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• There are four different sectors of an open
•
•
economy that buy real goods and services; public
consumption, business investment and public
spending on housing, government spending, and
exports and imports
Changes in any of these factors shifts the AD
curve
The largest component of aggregate demand is
generally consumption (C)
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AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Public consumption can change for a number of
•
•
•
reasons
It is sensitive to changes in consumer wealth
As consumer wealth changes, the level of
consumption changes in the same direction
As consumption increases, the AD curve will shift
to the right and vice versa
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17 – 14
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Changes in consumer expectations about the
•
•
•
course of economic events can change current
consumption
The more confident consumers are about the
future, the more likely they are to consume today
This would shift the AD curve to the right
Lower confidence levels would shift the curve to
the left
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17 – 15
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• The degree of consumer indebtedness also
•
•
effects consumption and aggregate demand
High level of indebtedness from past
consumption financed by borrowing must be
paid off and consumers may need to reduce
current consumption
As consumer spending falls, the AD curve
shifts left
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17 – 16
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• The government can affect consumption and
•
•
•
aggregate demand by adjusting the level of taxes
Higher taxes (or lower transfer payments) reduce
society’s after tax income
The lower income leads to lower consumption
spending and the AD curve shifts to the left
Of course, lower taxes (or higher transfer
payments) increase after tax income, thus
consumption, and the AD curve shifts to the right
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17 – 17
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Investment spending (I) is even more unstable
•
•
•
than consumption spending
Investment spending is sensitive to higher interest
rates
If interest rates change, aggregate demand will
change as investment responds to interest rate
changes
Higher interest rates tend to decrease business and
housing investment and lower interest rates tend
to increase it
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17 – 18
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• As economic conditions change, expectations of
•
•
future economic conditions generally change in
the same direction causing a change in investment
spending
The government can also change the level of
business taxation
Increases or decreases in the level of business
taxes tend to raise or lower investment spending
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17 – 19
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Government spending (G) can also influence the
•
•
•
level of aggregate demand
As government spending on goods and services
increases, aggregate demand increases
The opposite is also true
Government spending at federal, state or local
level in most countries is a sufficiently large
component of total spending to have a noticeable
impact on aggregate demand even when spending
changes are small
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17 – 20
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Aggregate demand may change because of
•
•
•
•
changes in exports (X) and imports (I)
These are caused primarily by changes in incomes
and the exchange rate
Exports are very sensitive to change in incomes in
foreign countries
As foreign incomes increase, exports from the U.S.
tend to increase which increases aggregate demand
As foreign incomes decline, exports fall and
aggregate demand decreases
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17 – 21
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• The more that fast economic growth happens in
•
•
•
•
the rest of the world, the greater will be the change
in U.S. aggregate demand
Movements in the real exchange rate can also
affect the level of exports and imports
As the dollar depreciates, a unit of foreign
currency will buy more U.S. goods and a dollar
will buy fewer foreign goods
This causes a change in aggregate demand
As exports and imports are a relatively small part
of the U.S. GDP, this is a trivial effect
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17 – 22
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
Table 17.1
Determinants or Factors that Shift the Aggregate
Demand Curve
Change in Consumption Spending
Change in Consumer Wealth
Change in Consumer Expectations
Change in Consumer Indebtedness
Change in Taxes
Change in Investment Spending
Change in Interest Rate
Change in Business Expectations
Change in Business Taxes
Change in Government Spending
Change in Federal, State, and Local Government Spending
Change in Exports and Imports
Change in Foreign Incomes
Change in Exchange Rates
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AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Aggregate Supply
• Aggregate supply is the relationship between the
•
•
total quantity of goods and services an economy
produces at various price levels, holding all other
determinant of production unchanged
The aggregate supply (AS) curve slopes upward
to the right
As price level rises, quantity of goods and
services economy produces increases
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AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
Figure 17.3
The Aggregate Supply Curve
Aggregate
Supply (AS)
Price Level
(P)
P1
B
P0
A
Y0
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Y1
Real GDP (Y)
17 – 25
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• The aggregate supply represents the entire
•
•
•
economy’s total production in the short run
Higher price level brings higher level of total
production in the economy
We assume that in the short-run, labor force,
capital stock, stock of natural resources, and level
of technology are held constant
The upward slope of the supply curve is related to
both rising demand for output and rising unit costs
as economy moves closer to full employment
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17 – 26
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Unit costs rise because as output expands, prices
•
•
•
of inputs rise before economy reaches full
employment
The various input markets have different demand
and supply curves
Because the price level is a weighted average of
different prices in the entire economy, some prices
may be rising while others remain constant
The price level on average may rise before the
economy reaches full employment
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AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• One of the most important prices in economy is
•
•
•
•
price of labor, or wages
As the economy expands, hiring more labor causes
the K/L ratio to fall in the short run
This results in a lower marginal output per unit of
labor and rising unit labor costs
Thus production costs rise as output increases
If the price level increases everything else
constant, the aggregate quantity supplied increases
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17 – 28
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Change in Aggregate Supply
• A change in the aggregate supply means that the
•
•
•
per-unit production costs are rising (falling) for
some reason unrelated to an increase in
production (output)
An increases in aggregate supply will shift the
curve to right
At any given price level, firms are willing and
able to produce more goods and services
Firms can produce same level of output at lower
unit costs, or unit costs have declined
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17 – 29
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
Figure 17.4
Changes in Aggregate Supply
Price Level
(P)
AS”
AS
AS’
Real GDP (Y)
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17 – 30
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• There are two types of changes or shifts in
•
•
aggregate supply
As the potential real GDP increases, the aggregate
supply curve shifts to the right
As the supply of factors of production (land, labor,
capital, entrepreneurial ability) increase over time,
the aggregate supply curve will shift right
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AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Increases in the productivity of factors of
•
•
production will reduce unit costs and shift the
aggregate supply curve to right
These movements are synonymous with a
country’s long run economic growth
We are interested in the type of shifts that result in
the short-run, less than one year
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AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Input prices used in the production of goods may
•
•
•
change
This causes an increase in the costs of production
and decreases aggregate supply
Many countries have experienced exchange rate
shock where there is a large shift in the real value
of a country’s currency in short period of time
This changes a firm’s costs of production changing
aggregate supply
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17 – 33
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Changes in business taxes can also cause a shift
•
•
in the AS curve
Increases in overall business taxes increases costs
of production decreasing AS and vice versa
The AS curve can also be influenced by changes
in the public’s inflationary expectations
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AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Perceived increases in future inflation cause
•
•
•
adjustments in economic action today
Producers may attempt to increase prices today to
stay ahead of anticipated inflation
Workers may attempt to receive larger salary
increases today to protect real wages and
standards of living
The aggregate supply curve will shift to the left
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17 – 35
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
• Aggregate Equilibrium
• The intersection of the AS and AD curves
•
•
•
determine an open economy’s equilibrium
If any of the determinants of the demand and
supply curves change, the equilibrium level of
output and the price level will change
Changes in the exchange rate can affect an open
economy’s equilibrium level of output and the
price level
Changes in the exchange rate can affect a
country’s trade flows
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17 – 36
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
Figure 17.6
The Equilibrium Price Level and Equilibrium Real
Output (GDP)
Aggregate
Supply (AS)
Price Level
(P)
Pe
E
Aggregate
Demand (AD)
Ye
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Real GDP (Y)
17 – 37
AGGREGATE DEMAND AND
AGGREGATE SUPPLY: A REVIEW
Table 17.2
Determinants or Factors that Shift the Aggregate
Supply Curve
Change in Factor Supplies
Change in Labor Force
Change in Capital
Change in Land
Change in Entrepreneurial Ability
Change in Productivity
Change in Input Prices
Change in Raw Material Prices
Change in the Price of Labor, etc.
Change in Exchange Rate
Change in Business Taxes
Change in Inflationary Expectations
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17 – 38
DETERMINANTS OF
THE CURRENT ACCOUNT
• Changes in aggregate demand and aggregate
•
•
•
supply influence output
We will focus on one component of aggregate
demand and supply – the current account
We want to examine how 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
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17 – 39
DETERMINANTS OF
THE CURRENT ACCOUNT
• Exports
• In the short run, a country’s exports are a
•
•
•
function of two major determinants
The first is the level of income in foreign
countries (Yf)
A country’s exports depend on foreigner's ability
to pay for the goods and services
As foreign incomes change, the level of a
country’s exports will also change
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17 – 40
DETERMINANTS OF
THE CURRENT ACCOUNT
• The second determinant of a country’s exports is
•
•
the real exchange rate (RXR)
As real value of country’s currency appreciates
(depreciates), the level of a country’s exports
declines (increases)
Size of the effect depends on the size of change in
real exchange rate
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17 – 41
DETERMINANTS OF
THE CURRENT ACCOUNT
• Imports
• The first determinant is the level of domestic
•
•
income (Yd)
As domestic income rises, the level of imports
rises
Size of effect depends on two factors, the size of
change in domestic income and the income
elasticity of demand for imports
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DETERMINANTS OF
THE CURRENT ACCOUNT
Table 17.4
Factors Determining the Current Account
Factor
Effect on
Foreign Income Increases
Exports Increase
Current Account Increases
Foreign Income Decreases
Exports Decrease
Current Account Decreases
Real Exchange Rate Increases
Exports Increase
Current Account Increases
Exports Decrease
Real Exchange Rate Decreases
Exports Decrease
Current Account Decreases
Exports Increase
Domestic Income Increases
Exports Increase
Current Account Decreases
Domestic Income Decreases
Exports Decrease
Current Account Increases
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EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
• In the short run, the aggregate demand curve is the
•
link between the current account balance and
output of the entire economy
Because real exchange rate changes impact the
current account, we can link real exchange rate
changes to changes in domestic economy’s output
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17 – 44
EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
• Exchange Rate Appreciation
• Equilibrium exchange rate equates inflows and
•
•
outflows of foreign exchange at XRe
Assume this rate is associate with purchasing
power parity
The equilibrium exchange rate determines the
country’s imports, exports, and initial level of
aggregate demand
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17 – 45
EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
Figure 17.7b
The Exchange Rate and Equilibrium Output
Price Level
(P)
AS
Pe
F
P’
G
AD’
Y’
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Ye
AD
Real GDP (Y)
17 – 46
EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
• Assuming no capital flows between countries,
•
•
•
foreign trade is balanced and the economy is at
equilibrium
If the real exchange rate changes and the currency
appreciates, the supply of foreign exchange will
increase
The equilibrium in the foreign exchange market
changes and the real exchange rate appreciates
Exports would fall and imports would rise
resulting in a current account deficit
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EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
• As the current account moves into deficit, the
•
•
aggregate demand will decline as exports decline
and imports increase
The aggregate demand curve would shift to the left
The real appreciation of the currency causes a
decrease in the equilibrium level of total output
(real GDP)
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17 – 48
EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
• Price level also falls as aggregate demand
•
•
•
decreases
With appreciating currency, the price of imports
declines
Price of domestic goods that compete with imports
may fall as a result
The net result is that the domestic price level falls
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17 – 49
EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
• Exchange Rate Depreciation
• When a currency depreciates, the demand for
•
•
•
foreign exchange increases
With no capital flows, there is equilibrium and
balanced trade
As the exchange rate depreciates, a current
account surplus would occur
Exports increase and imports decrease as the
price of domestic goods falls
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17 – 50
EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
• As the current account moves into surplus,
•
•
aggregate demand increases as exports increase
and imports decrease
The domestic real GDP increases as total output
increases
The net result of a depreciating currency is a
higher level of output and a higher price level
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EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
Figure 17.10b
The Effect of a Depreciation of the Currency
Price Level
(P)
AS
P’
F
Pe
G
AD’
AD
Ye
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Y’
Real GDP (Y)
17 – 52
EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
Figure 17.11a
The Effect of a Major Devaluation
Exchange Rate
(XR)
XR”
S”
S
F
E
XRe
D”
D
FXe
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Foreign Exchange (FX)
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EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
Figure 17.11b
The Effect of a Major Devaluation
Price Level
(P)
AS”
P”
AS
H
Pe
G
AD
Y”
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
Ye
Real GDP (Y)
17 – 54
EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
• Exchange Rate Shocks
• Suppose a currency experiences a 75%
•
•
•
depreciation in one week
Demand for foreign exchange would dramatically
increase and the supply would decrease
The equilibrium changes and the exchange rate
would change
This could be the result of capital flight out of
country due to a domestic crisis or due to
exchange rate being fixed at inappropriate level
for long period of time
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17 – 55
EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
• The effects on a domestic economy can be
•
•
•
calamitous in the short run
Large changes in the exchange rate in the short run
can have a substantial effect on the aggregate
supply curve
If depreciation is large, the effects can be
substantial
Depreciation causes a large short-run increase in
the cost of production
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17 – 56
EXCHANGE-RATE CHANGES AND
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
• The aggregate supply curve would shift to the left
• This reduction in output may be enough to cause a
•
•
major recession
The economy is now faced with lower output and
higher prices
While uncommon in developed countries, they are
common in developing countries and avoiding
these is a major task for policymakers in these
countries
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17 – 57
SUMMARY
1. The real exchange is important because it affects
the level of international trade and the rate of
growth of GDP in the short run
2. The general framework employed to analyze the
effects of real exchange rate changes on domestic
output and the price level is called the aggregate
demand and aggregate supply model
3. Aggregate demand is the relationship between
total quantity of goods and services that all sectors
of society demand and the price level
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17 – 58
SUMMARY
4. The negative slope of the aggregate demand curve
indicates that as the price level rises, the values of
people’s real wealth decreases and spending
declines, interest rates increase and spending
declines, the price of domestically produced goods
rises with respect to foreign goods and exports
decline and imports increase
5. When one of the determinants of aggregate
demand that has been held constant changes, the
aggregate demand curve will shift
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17 – 59
SUMMARY
6. Aggregate supply is the relationship between total
quantity of goods and services an economy
produces at various price levels, holding all other
determinants of production constant
7. The aggregate supply curve will shift if one of the
determinants of aggregate supply that has been
held constant changes
8. The intersection of the aggregate demand and
aggregate supply curves determines an open
economy’s equilibrium level of output and the
price level
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17 – 60
SUMMARY
9. Changes in the current account influence
the equilibrium level of output
10. The link between the current account
balance and the entire economy’s output in
the short run is through a country’s
aggregate demand
11. Dramatic changes in the real exchange rate
can affect the domestic economy through
changes in the aggregate supply curve
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