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Chapter Nineteen
Prices and Output in an
Open Economy
© 2003 South-Western/Thomson Learning
Chapter Nineteen Outline
1. Introduction
2. Apples vs. GDP: Supply in Micro- and
Macroeconomics
3. Aggregate Demand under Fixed Exchange
Rates
4. Long-Run Aggregate Supply
5. Medium-Run Aggregate Supply
6. Combining Aggregate Demand and
Aggregate Supply
2
Chapter Nineteen Outline
7. Macroeconomic Policy under Fixed
Exchange Rates
8. Aggregate Demand under Flexible
Exchange Rates
9. Macroeconomic Policies under Flexible
Exchange Rates
10.Supply Shocks
3
Introduction
• We have examined the effects of
macroeconomic policies in the short- and
long-run. Now it is time to study those effects
in the medium-run.
• Two definitions:
1. A sustained rise of the overall price level defines
inflation.
2. A sustained fall in the price level, rarely
observed, represents deflation.
• Need to distinguish between the supply, or
production, side of the economy and the
demand, or expenditure, side.
4
Apples vs. GDP: Supply in Micro- and
Macroeconomics
• The effects of changes of price and supply in
the apple market is shown in Figure 19.1:
– In panel (a), the supply curve for apples is
perfectly horizontal.
• The price of apples is fixed, and demand determines
quantity.
– In panel (b), the supply curve for apples is upward
sloping, reflecting the movement of resources into
and out of apple production in response to relative
price changes.
See
Figure
19.1
5
Figure 19.1: Price and Supply in the
Apple Market
Papples
Papples
S
P0= P1
S
P1
P0
D1
D1
D0
D0
0
Q0
(a)
Q1
Qapples
0
Q0 Q1
Qapples
(b)
6
Aggregate Demand under Fixed Exchange
Rates
• An economy’s aggregate demand curve
represents the relationship between the
quantity demanded of domestic goods and the
domestic price level.
– The quantity examined represents the economy’s
total output of goods and services, or GDP.
– The relevant price represents the overall domestic
price level, the GDP deflator.
7
Aggregate Demand under Fixed Exchange
Rates
• The slope of the aggregate demand curve.
– Slopes downward like a microeconomic demand
curve, but for different reasons:
1. A rise in the domestic price level raises the price of
domestic goods relative to that of foreign ones.
2. The quantity demanded of real money balances
depends positively on real income and negatively on
the interest rate.
8
Aggregate Demand under Fixed Exchange
Rates
• The effects of a rise in the price level in the
money market is shown in Figure 19.2:
– A rise in the price level from P0 to P1 reduces the
real money stock (M/P), assuming that the nominal
money stock (M) is held constant.
• The equilibrium interest rate rises to reduce the
quantity demanded of real money balances to equal the
new, smaller stock.
See
Figure 19.2
9
Figure 19.2: Effect of a Rise in the Price
Level in the Money Market
i
(M 0 /P1)
(M 0 /P0)
(P1 > P0)
i1
i0
L(Q0, i)
0
(M 0 /P1)
(M 0 /P0)
Quantity of Real
Money Balances
10
Shifts in the Aggregate Demand Curve
• A change in nominal money stock, fiscal policy
variables, the nominal exchange rate, or foreign
price level alters the demand for domestic
goods at each domestic price level, and
therefore, shifts the aggregate demand curve.
– Figure 19.3 illustrates the various shifts in the
aggregate demand curve (next slide).
11
Figure 19.3: Shifts in the Aggregate Demand
Curve
P
Fall in e (revaluation)
Decrease in M
Decrease in G or increase in taxes
Fall in P *
Rise in e (devaluation)
Increase in M
Increase in G or decrease in taxes
Rise in P *
AD2
AD0
AD1
0
Q
12
Shifts in the Aggregate Demand Curve
• The demand for domestically produced goods
is reduced at each domestic price level by
revaluation of domestic currency, decline in
domestic nominal money stock, decrease in
government purchases, rise in taxes, or a fall
in foreign price level.
13
Shifts in the Aggregate Demand Curve
• Demand for domestically produced goods
increases at each domestic price level due to
devaluation of domestic currency, rise in
domestic money stock, an increase in
government purchases, reduction in taxes, or a
rise in foreign price level.
– Changes in the domestic price level itself, other
things being equal, cause movements along a single
aggregate demand curve rather than shifts in it.
14
Long-Run Aggregate Supply
• Aggregate supply refers to the relationship
between an economy’s price level and the total
quantity of goods and services produced.
– Quantity of available resources and existing
technology constrain the total quantity of output
an economy can produce.
• The short, medium, and long runs
– Short run: period during which the price level
remains fixed in response to economic shocks or
policy changes, so aggregate demand alone
determines real output.
15
Long-Run Aggregate Supply
– Medium run: the period during which the price
level begins to respond to shocks or policy changes,
but individuals or firms may remain unaware of
some price changes or may find it too costly due to
contracts or other rigidities to adjust their
behavior in response to those changes.
– Long run: denotes the time over which everyone in
the economy knows the price level and has had
time to adjust production decisions accordingly.
16
The Vertical Long-Run Aggregate Supply
Curve
• The long-run aggregate supply (LRAS) curve
is a simple vertical line at the economy’s fullemployment output, implying that changes in
the price level have no effect on the quantity of
output supplied.
– Figure 19.4: in the long-run, the quantity of output
does not depend on the price level.
• The economy’s quantity of resources and technology
determine the horizontal placement of the LRAS curve.
See Figure 19.4
17
Figure 19.4: Long-Run Aggregate Supply
P
LRAS
P2
P1
0
Q
18
Medium-Run Aggregate Supply
• Medium-run aggregate supply (MRAS) curve
captures the behavior of individuals and firms
when lack of information about the price level,
stickiness of some prices, or inability to adjust
quickly to a change in the price level causes
behavior to differ from what it would be with
full information and instantaneous
adjustment.
19
Medium-Run Aggregate Supply
• The slope of MRAS curve is represented in
Figure 19.5:
– A rise in the price level causes an increase in the
quantity of output supplied.
• This is captured by the upward-sloping portion of the
MRAS curve.
• At some point, the economy reaches the constraint of
resources and technology, causing the medium-run
aggregate supply curve to become vertical.
See Fig. 19.5
20
Figure 19.5: Medium-Run Aggregate Supply
P
LRAS
MRAS
P0
0
Q
21
Shifts in the MRAS Curve
• Each MRAS curve is drawn for given values of
input prices and of firms’ expectations about
prices other than those of their own products.
– If price level rises, but contractual rigidities keep
some input prices constant and firms do not
immediately alter their expectations about other
prices, firms will perceive relative prices of their
outputs as having risen and will increase output.
• This causes the economy to move up along a given
MRAS curve, as depicted in Figure 19.6.
See Figure 19.6
22
Figure 19.6: Vertical Shift in the Medium-Run
Aggregate Supply Curve
P
LRAS
e
MRAS(W1, P1 )
e
MRAS(W0, P0 )
(W1 > W0, Pe1 > P e0 )
3
P1
P0
2
1
P2
0
Q
23
Combining Aggregate Demand and
Aggregate Supply
• Assume perfectly mobile capital:
– Portfolio owners, in deciding where to put their funds,
consider only interest rates, exchange rates, and expected
changes in exchange rates.
• No government regulations restrict capital flows among
countries.
– In the medium-run, as shown in figure 19.7, the economy
must be at the intersection of AD curve and MRAS curve.
– In long-run, this intersection must occur also on the
LRAS.
See Figure 19.7
24
Figure 19.7: Medium-Run and Long-Run
Equilibrium
P
LRAS
MRAS
Medium run:AD = MRAS
P1
Long run:AD = MRAS = LRAS
P0
AD1
AD0
0
Q0 Q 1
Q
25
Macroeconomic Policy under Fixed Exchange
Rates
• Without fixed price levels, the economy
contains automatic adjustment mechanisms for
reaching long-run equilibrium.
– Mechanisms that do not require active responses
from policy makers.
– At this equilibrium, the following statements are
true:
1. The quantity demanded of domestic goods equals the
quantity supplied at full employment; and
2. BOP equilibrium prevails.
26
Macroeconomic Policy under Fixed Exchange
Rates
• Primary shortcoming of automatic adjustment
mechanisms is their lack of speed.
• In the medium-run, fiscal policy can alter
income, but monetary policy cannot.
– Neither policy can affect real output in the longrun, although fiscal policy continues to affect the
price level.
27
Macroeconomic Policy under Fixed Exchange
Rates
• Fiscal policy, prices, and output
– The effects of an expansionary fiscal policy with
flexible prices, fixed exchange rates, and perfectly
mobile capital are shown in Figure 19.8:
• Beginning from a long-run equilibrium at point 1,
output is raised temporarily.
– As firms and individuals adjust to the rise in the price level, the
increase in output is offset, and the long-run effect is merely a
rise in the price level and there is no effect on real output.
See Figure
19.8
28
Figure 19.8: Effects of Expansionary
Fiscal Policy
P
LRAS
MRAS2
MRAS1
P2
P1
3
1
2
AD3
AD2
AD1
0
Q
29
Macroeconomic Policy under
Fixed Exchange Rates
• Fiscal policy, prices, and output (cont.)
– Two alternative paths to long-run equilibrium are
compared in Figure 19.9:
• Expansionary fiscal policy vs. automatic adjustment:
See
Figure
19.9
– Beginning at point 1, expansionary fiscal policy brings the
economy to a new long-run equilibrium at point 2b.
– Automatic adjustment leads to a long-run equilibrium at point
2a.
– In either case, the location of the LRAS curve determines
output.
– The equilibrium price level is higher in the case of
expansionary fiscal policy (P2) than in that of automatic
adjustment (P0).
30
Figure 19.9: Expansionary Fiscal Policy versus
Automatic Adjustment
P
LRAS
MRAS1
MRAS0
P2
P1
P0
2b
1
2a
AD2
AD1
0
Q
31
Macroeconomic Policy under
Fixed Exchange Rates
• Monetary policy, prices, and output.
– Monetary policy cannot affect income with a fixed
price level, a fixed exchange rate, and perfectly
mobile capital.
• Conclusion continues to hold when we introduce price
flexibility.
– When the economy operates at less than fullemployment and as long as the price level is flexible,
the price adjustment mechanism pushes output toward
its long-run level.
– As for the BOP, the fixed exchange rate implies that
the money stock adjusts – through changes in FX
reserves – to equate the BOP.
32
Macroeconomic Policy under
Fixed Exchange Rates
• Exchange rate policy, prices, and output.
– Third type of possible macroeconomic policy involves
a permanent change in exchange rate, such as a
devaluation (Figure 19.10).
See
Figure
19.10
• Beginning at point 1, the devaluation lowers the relative
price of domestic goods and switched expenditure
toward them.
– The AD curve shifts right from AD1 to AD2.
– At point 2, the BOP is in surplus due to the
devaluation. Intervention in the FX market increase
domestic money supply, and the AD curve shifts
further right.
• MRAS curve moves upward.
• Long-run equilibrium is restored at point 3.
33
Figure 19.10: Effect of a Devaluation with
Flexible Prices . . . Perfectly Mobile Capital
P
LRAS
MRAS3
MRAS1
P3
3
P2
P1
1
2
AD3
AD2
AD1
0
Q
34
Aggregate Demand under Flexible Exchange
Rates
• Just as it does under a fixed exchange rate
regime, the AD curve under a flexible regime
captures the negative relationship between the
domestic price level and the quantity
demanded of domestic goods and services.
– Slope of AD curve: downward for same reasons as
under a fixed regime.
1. Rise in price level raises the relative price of domestic
goods and shifts expenditure toward foreign goods.
2. Rise in domestic price level lowers real money stock,
raises domestic interest rate, lowers investment, and
causes capital inflows and currency appreciation.
35
Aggregate Demand under Flexible
Exchange Rates
• Shifts in AD curve.
– Situation 1: Permanent increase in money stock…
• Raises real money stock and lowers interest rate; causes
capital outflow, which depreciates domestic currency
and lowers relative price of domestic goods.
– Implies larger quantity of domestic goods at each price level –
AD curve shifts right.
– Situation: Permanent rise in government
purchases…
36
Aggregate Demand under Flexible
Exchange Rates
• Shifts in AD curve.
– Situation 2: Permanent rise in government
purchases…
• This change has no effect on aggregate demand under a
flexible regime and perfect capital mobility.
– Interest rate rises to make individuals content to hold only the
available stock of real balances.
– Capital flows in, domestic currency appreciates, and relative
price of domestic goods rise.
– Net exports fall enough to offset initial increase in government
purchases.
– Total demand remains unchanged.
37
Macroeconomic Policies under Flexible
Exchange Rates
• Automatic adjustment mechanisms
– When both the price level and the exchange rate
are flexible, the economy contains automatic
adjustment mechanisms for bringing it into
equilibrium on the long-run supply curve with
balance payments.
• Price level adjusts to equate the quantity demanded of
domestic goods with quantity supplied at full
employment.
• Exchange rate adjusts to bring the BOP into
equilibrium.
38
Macroeconomic Policies under Flexible
Exchange Rates
• Macroeconomic policy, prices, and output.
– The effects of expansionary monetary policy with
flexible prices, flexible exchange rates and
perfectly mobile capital are depicted in Fig. 19.11:
• Beginning from a point of long-run equilibrium at point
1, expansionary monetary policy can raise output, but
only temporarily.
See
Figure
19.11
– As individuals and firms adjust to accompanying rise in price
level, output falls back to original level.
– Policy’s long-run effect consists solely of a proportional rise in
price level and proportional depreciation of domestic currency.
39
Figure 19.11: Effect of Expansionary Monetary
Policy . . . Perfectly Mobile Capital
P
LRAS
MRAS2
MRAS1
P2
3
2
P1
1
AD2
AD1
0
Q
40
Macroeconomic Policies under Flexible
Exchange Rates
• Exchange rate overshooting: occurs when a
variable responds to a disturbance more in the
medium-run than it does in the long-run.
• Tends to occur when some variables adjust more quickly
than others.
• Figure 19.12 contrasts expansionary monetary
policy with automatic adjustment:
• Beginning from point 1, expansionary monetary policy
leads to a long-run equilibrium at point 2a with price
level P1.
• Automatic adjustment leads to long-run equilibrium at
2b with price level P2.
See Figure 19.12
41
Figure 19.12: Expansionary Monetary Policy
versus Automatic Adjustment
P
LRAS
MRAS1
MRAS2
P1
2a
1
P2
2b
AD2
AD1
0
Q
42
Supply Shocks
• Supply shocks: include any event that alters
the economy’s long-run equilibrium
productive capacity.
– Examples include earthquakes, floods, wars, and
oil embargoes.
• Definition of stagflation: combination of rising
prices and declining output.
43
Supply Shocks
•
Effects of an adverse supply shock and potential
policy responses are illustrated in Figure 19.13:
–
–
Shock shifts MRAS and LRAS curves left.
Policy makers have several options:
1.
See
2.
Figure
19.13
3.
4.
–
Can leave AD unchanged at AD0; new long-run equilibrium at point
3a.
Expand AD to AD1 to speed the economy’s return to full employment
at point 3b; prices rise.
Aggressively expand AD to AD2 and push output back to its pre-shock
level; much higher prices at 4c.
Contract AD to AD3 and restore long-run equilibrium at point 4d;
keeps prices down but may require higher unemployment.
Regardless of choice, the new long-run, full-employment
output is at the lower Q1.
44
Figure 19.13: An Adverse Supply Shock and
Potential Policy Responses
P
LRAS1 LRAS 0
MRAS1
MRAS2
4c
Pc
MRAS0
3c
Pb
P2
Pa
3b
2
AD2
3d
3a
P1
1
Pd
4d
AD1
AD0
AD3
0
Q1
Q0
Q
45
Note for Case 1: Unemployment – Structural
and Cyclical
• Figure 19.14: 1999 unemployment rates for 21
developed-country members of the OECD plus
for the 11-member euro area.
– Each country’s actual unemployment rate
(illustrated by the red line) can be decomposed into
a structural component (the blue bars) and a
cyclical component (difference between the height
of the bar and that of the line).
See
Figure 19.14
46
Figure 19.14: Unemployment Rates’ Structure and
Cyclical Components, 1999 (% Labor Force)
47
Note for Case 2: Government Budgets –
Structural and Cyclical
• Figure 19.15 illustrates the Japanese fiscal
policy indicators for 1990-90.
– The country’s fiscal policy stance turned
contractionary in 1997 when the government
increased taxes.
• The Japanese economy already stood at the brink of a
recession, and the fiscal contraction pushed further in
that direction.
See Figure 19.15
48
Figure 19.15: Japanese Fiscal Policy
Indicators, 1990-1999 (Percent)
49
Note on the Appendix: The Aggregate
Demand Curve
• Figure 19A.1 represents the derivation of
aggregate demand curve from IS-LM-BOP
with perfectly mobile capital.
– Real output and the price level are negativelyrelated along an aggregate demand curve.
See
Figure
19A.1
50
Figure 19A.1a: Derivation of Aggregate
Demand Curve
i
LM
1 (M/P1
)
(a)
LM
0 (M/P 0
)
BOP
IS
IS
IS
IS
0
1
3
2
0
Q
2
Q
3
Q
1
Q
0
Q
51
Figure 19A.1b: Derivation of Aggregate
Demand Curve
(b)
P
P1
P0
AD (fixed rate, high elasticity)
AD (flexible rate)
AD (fixed rate, low elasticity)
0
Q2
Q3
Q1
Q0
Q
52
Summary
• The introduction of price flexibility in this
chapter has three major implications:
1. Economy now contains an automatic adjustment
mechanism for bringing output to its long-run
equilibrium level at full employment.
2. Remaining effective tools of macroeconomic policy
can permanently increase output only if the
economy is operating temporarily to the left of the
LRAS and only by raising the price level.
3. Expansionary macroeconomic policy can
permanently affect only the price level and not the
level of real output or employment.
53
Key Terms in Chapter 19
• Inflation
• Deflation
• Aggregate demand curve
• Aggregate supply
• Short run
• Medium run
• Long run
• Long-run aggregate supply curve
54
Key Terms in Chapter 19
• Medium-run aggregate supply curve
• Perfectly mobile capital
• Automatic adjustment mechanisms
• Price adjustment mechanism
• Overshooting
• Supply shocks
• Stagflation
55