Download Chapter 16 - UCSB Economics

Chapter 16
Topics:
Aggregate Demand
Equilibrium in the goods market: DD curve
Asset market: AA curve
Overall Equilibrium
Temporary Policies
Permanent monetary policy
Current account implications
J-curve and pass-trhough
1. Aggregate Demand
a) Definition: the amount of a country’s goods and services that people at home and
abroad together are willing and able to purchase. We represent this as D. There are
several components to aggregate demand: D = C + I + G + CA (demand is sum of
consumption, investment , government expenditure and foreign demand)
b) What determines consumption? The main determinant here is disposable income:
Yd = national income - taxes.
Write this as: C = C(Yd). This means that consumption is an (increasing) function of
disposable income.
c) Consider what determines the current account, EX – IM.
1. An increase in Yd makes consumers want to consume more goods –foreign as
well as domestic. So imports rise, CA falls.
2. Recall that the real exchange rate is the relative price of a representative
basket in foreign country in terms of a representative home basket. We
express this as q = EP*/P, where E is the nominal exchange rate, P* is the
foreign price level, and P is the home price level. q affects CA because it
affects the price of domestic goods relative to foreign goods. (Do examples,
p. 439 and another one)
For example, if EP*/P rises, this means foreign products are more expensive.
Any element of this expression could cause the change. Such a change
increases exports, because your goods are cheaper and more attractive. The
effect on imports is ambiguous: It decreases number Jaguars will buy, because
they are more expensive, but since each Jaguar is worth more $, it is possible
that the total # of dollars being spent on importing Jaguars rises. We assume
for now that CA will improve when the real E rises.
So, we consider that CA = CA(EP*/P, Yd).
d) We can summarize this in the equation of aggregate demand:
D = C(Y-T) + I + G + CA(EP*/P, Y-T)
or
D = D(EP*/P, Y-T, I, G)
Consider the effect on D of:
1) A real depreciation (rise in EP*/P) makes domestic goods cheaper relative to
foreign goods, so it shifts domestic and foreign spending from foreign goods to
domestic goods, so CA increases and aggregate D increases.
2) A rise in income raises consumption, which raises D. However, part of
consumption is on foreign goods, so a rise in imports (CA falls) lowers D.
Overall, an increase in Y causes D to rise, but less so than in closed economy
where we don’t consider CA.
Discuss Fig. 16.1. The idea is that an increase in Y also stimulates demand, but part of this leaks
away abroad because imports rise. So the slope is flatter than 45 degrees. Note that the D line
starts at a positive vertical intercept, as even if there is no income, we still want to consume
something, and government expenditures are positive even if Y=0.
Recall that in the short run, we assume that prices are temporarily fixed. A change in output
eventually leads to a change in prices.
2. Short-run equilibrium in the goods market
The equilibrium condition is that demand for goods and services equals the amount being
produced, so that aggregate demand equals output: Y = D(EP*/P,Y-T,I,G).
Discuss Fig. 16-2. The line for Y= D goes through the origin and has a 45 degree angle. The
equilibrium is at Y1. Equilibrating forces: a) If we are at Y2, D exceeds output; this depletes the
inventories of firms, so they produce more. Y increases until it equals D; b) If we are at Y3, D is
less than Y, so inventories build up (involuntarily), so firms produce less, until Y= D.
This should be familiar from previous macro classes. But we now want to consider the
relationship to the exchange rate.
In Fig. 16-3, we consider the effect of a (nominal) currency depreciation on output. Since
prices are fixed, this makes domestic goods more attractive, and the aggregate demand
curve shifts up. Any rise (fall) in EP*/P (from whichever component) leads to an upward
(downward) shift in aggregate home demand. There is a new equilibrium in the goods
market, as increased demand will deplete inventories and cause firms to produce more.
This is taking E as given. What if E rises (domestic currency depreciates)? Consider Fig.
16-4, which shows how to derive the DD schedule. Start with the E-rate in the bottom
part of the Figure and the associated aggregate demand in the upper half. Given fixed
prices, a depreciation from E1 to E2 will cause the real exchange rate to rise (home goods
become cheaper). This shifts D up, because $ depreciation stimulates exports and
dampens imports. The intersection of the aggregate demand curve with the D=Y line
gives equilibrium demand, and is reflected down to the bottom half. Doing this for every
exchange rate generates the DD schedule, which summarizes the effect of a change in Y
on the goods market equilibrium.
Factors that shift the DD schedule
a) An increase in government expenditure: (example: need to pay Ken Lay’s
mortgage for him), shown in Fig. 16-5. Increasing G leads to an increase in D
(aggregate demand) at any given output level (shown in top half). So the
equilibrium Y will be higher, given no change in the assumed E-rate.
Therefore, the DD schedule must shift to the right in the bottom half.
b) An increase in taxes leads to lower disposable income, so consumption falls,
shifting the D curve downward (top half), and a higher equilibrium value of Y.
As there is a higher equilibrium Y for any given E, the DD curve must shift left
(bottom half).
c) An increase (decrease) in I has same effect here as an increase (decrease) in G.
d) An increase in P (and we assume no change in E and P*) makes home output
more expensive, so shifts demand downward, causing DD to shift to the left.
e) An overall increase in the C function (happened in the U.S. in 1980’s) shifts D
and DD as in a) and c) above.
f) A switch in tastes away from foreign goods to home (tastes change - in 1980’s,
when the oil price dropped, there was a shift back to bigger U.S. cars) means less
imports and more exports, so CA improves, D shifts up, and DD shifts to the
right.
General principle: if a shock increases (decreases) aggregate demand for a given
E, this will shift DD to the right (left). Note the distinction between movement
along the curve and shifts in the curve.
3. Short-run equilibrium in the asset market
Overall equilibrium in the economy requires simultaneous equilibrium in both the
goods market and the asset market. The AA schedule summarizes the
combinations of output and E-rates that are consistent with equilibrium in both the
domestic money market and the foreign exchange market.
We now vary output (Y). A change in Y can affect asset market. Recall the
interest parity condition, and how R must also equate the real domestic money
supply Ms/P with aggregate real money demand L(R,Y).
A temporary increase in output (so no change expected in E-rate) increases
money demand, because there are more goods people want to buy. Consider Fig.
16-6.
First, a rise in Y increases money demand (shifts L(R,Y) downward; remember
this bottom half is rotated 90 degrees). This increases the interest rate, because
there is a need to ration out the existing supply of money. The lower interest rate
translates up to the foreign exchange market half of the Figure, making the current
E-rate fall. The domestic currency appreciates enough so that the expected
depreciation in the future (recall that this is a temporary increase in Y) offsets the
increased interest rate advantage of the home currency (as in Chapter 14).
So, overall, for asset markets to be in equilibrium, a rise (fall) in domestic output
is associated with a (temporary) appreciation (depreciation) of the domestic
currency, all else equal.
Thus, the AA schedule must slope downward, as is illustrated in Fig. 16-7.
Factors that shift the AA schedule
a) An increase in the money supply will cause the home currency to depreciate.
So for a given level of output, E is higher after the rise in Ms. Thus, an increase
in the money supply shifts the AA curve to the right.
b) A fall in price level increases the real money supply, as in a). MS/P line shifts,
R falls, currency depreciates. So for given Y, E is higher.
c) A rise in the expected exchange rate shifts the foreign return line right (top half
of Fig. 16-6) and makes the current E rise, shifting the AA schedule to the right
(equivalently, upward).
d) A rise in the foreign interest rate is just like a) – shifts the curve in the top half
of Fig. 16-6 to the right, so (given output) the home currency must depreciate to
maintain interest rate parity.
e) A fall in money demand (for any given Y or R): shifts the L curve to the left, R
falls, so E rises and the home currency depreciates for any given Y. So AA
shifts right.
4. Short-run equilibrium for an open economy: Putting DD and AA together
We have two curves that show the short-run relationship between E and Y. Fig. 16-8
shows how to put these together.
The asset market says that, given a Y, we will have a certain E. Y also implies a level of
Md, which implies an R, which implies a certain demand for the domestic currency
deposits, which by the interest rate premium implies a certain E.
The goods market says that, given an E, we will have a certain Y. E implies that the
relative price of home and foreign goods, implies a certain CA, which implies a certain
Y.
The intersection represents equilibrium for an open economy.
In Fig. 16-9, point 1 is the equilibrium. Suppose we instead started off at point 2, where
both markets are out of equilibrium.
1) Jump down to AA to point 3: Currency is overvalued relative to what IRP says
it should be. Given the expected future E, expected depreciation is larger than
the interest rate differential, so investors get out of $ deposits, leading to $
depreciation. This leads to an immediate drop in E, moving from point 2 to
point 3.
2) However, point 3 is still above DD, so the goods market is not in equilibrium.
The low value of domestic currency makes home goods inexpensive, so CA is
high. This means aggregate demand > output, so firms will increase
production and output increases; Move right along AA; the currency must
appreciate to lower the expected rate of future domestic currency appreciation
and maintain interest rate parity.
3) The forces are at rest when at point 1.
5. The effect of temporary changes in monetary and fiscal policies
We consider the effect of temporary changes (somehow it is plausible that these are
temporary). Assumptions: 1) long-run (full-employment, after adjustments) future
exchange rate is perfectly anticipated; 2) temporary policies do not affect long-run
expected E-rate; 3) R* and P* are unaffected, and P is fixed in the short run.
a) Monetary policy
As shown in Fig. 16-10, a temporary increase in Ms (given price fixed) shifts AA
to the right (E-rate higher keeping the level of output the same), but doesn’t change
the position of the DD schedule. Thus, the exchange rate rises (home currency
depreciates), there is more output demand and so output rises.
b) Fiscal policy
As shown in Fig.16-11, a temporary increase in G (or a temporary tax cut or some
combination) shifts the DD curve to the right, so the equilibrium Y rises and E
falls. The logic is that: 1) in the goods market, there is an increased level of
demand at any given exchange rate. The increased demand leads to an increase in
output, and 2) in the asset market, an increase in Y makes the money demand
increase, which makes R rise, this makes $-assets more attractive, this makes the
$ appreciate (E decreases).
(Note: this is similar to the ISLM model learned in earlier classes, but here we focus
on E instead of on R – we use E instead of R on the vertical axes of the graphs.)
c) Maintaining full employment in the face of temporary shocks
Suppose there is a temporary drop in world demand, so that we are no longer at
full employment. Consider a temporary change in tastes (for example, people stop
liking big American cars). In Fig. 16-12, this shifts the DD schedule left and
leaves the position of the AA schedule unchanged, so E increases ($ depreciates)
and Y decreases.
There are two policy options (can be combined) to restore Y to the full-employment
level:
a) Fiscal policy: Increase government expenditure (e.g., buy the American cars no one
else wants, or buy tanks and put car workers to work on them). This shifts the DD
schedule back to its original position.
b) Monetary policy: Increase the money supply, shifting the AA schedule to the right.
This makes the dollar depreciate (then the U.S. cars are cheaper for foreign buyers, so
some people buy more US cars again).
.
Both policies can make Y increase temporarily. However, there is a difference in the
implications for E.
Alternatively, consider a temporary rise in money demand (e.g., the stock market
crash of 1987). People got out of stock market and wanted to hold money instead.
We can view this as a rise in Md. In Fig. 16-13, this shifts AA left, causing a fall in Y.
Policy Options
1) Do what the Fed did: Accommodate the demand for money by increasing Ms to
make AA curve go back to where started. Back to normal. This is perhaps its most
widely praised monetary policy action.
2) Could have increased government expenditure. But why do this? It takes longer,
and improves Y through a different channel. It is ideally better to work through
the same channel through which the shock arose.
d) Inflation bias and other problems with policy formulation
It’s not always so easy.
In practice, there are political timing considerations (e.g., raise output just
before an election) and people may anticipate these. If anticipated, it may
be necessary to use expansionary policies just to avoid contraction. This
leads to an inflation bias. The problem is really one of commitment by
the government. Also, it may not be clear where the economic disturbance
originates. Finally, fiscal policy requires a lot of bureaucratic
maneuvering, whereas monetary policy is relatively easy to change.
6. Permanent shifts in monetary and fiscal policy
Permanent shifts change expectations. We assume that prices are flexible, the economy
is initially at long-run equilibrium and that initially R = R*.
a) A permanent change in monetary supply
Recall the AS theory of macro: the long-run output level is determined by the supply
side of the economy - how much can be produced with all factors of production fully
employed. Monetary policies can temporarily raise output above the fullemployment level, but not in long run.
Suppose that there is a permanent money supply increase, as depicted in Fig. 16-14.
The short-run effect is to shift the AA schedule to the right, so that E increases and
the $ depreciates. As was seen in Chapter 14, a permanent increase in the money
supply has a greater effect on the exchange rate than a temporary increase (review
Fig. 14-10), due to the change in the expected euro return (and leads to overshooting).
So, in the short run AA shifts out more than with a temporary increase.
The adjustment process in the long run is shown in Fig. 16-15. At point 2 in Fig. 1614, the economy is over-heated (output above full-employment level). This is not
sustainable. In the long run, the price adjusts and R returns to original level and AA
moves left. But the effect on the expected long-run E remains, so AA doesn’t move
all the way back to its original position. A rise in price will also cause domestic
goods to be more expensive in relation to foreign goods, so the DD schedule shifts to
the left.
In the long run, we end up back at full employment, but we still have the long-run
increase in E that is proportional to the permanent increase in the money supply. The
adjustment path is kind of cool – it shows the overshooting we talked about in
Chapter 14.
b) A permanent fiscal expansion
This is shown in Fig. 16-16; it not only has an immediate effect on the output market,
but also affects long-run exchange rate expectations. The direct effect of the fiscal
expansion is to shift DD to the right, as before.
But the permanent fiscal expansion (e.g., $5 billion per year extra to be spent on
space program) causes a long-run appreciation of the currency, associated with the
AA schedule moving to the left. So, in the long run, the expansionary effect is
eliminated by the appreciation of the $ - we end up at the same output level (point 2),
rather than the short-run outcome (point 3).
Why is this ineffective? The text suggests a proof by contradiction: The fiscal
expansion doesn’t affect the money supply, or R, or Yf. Suppose Y does rise (long
run). Since the real money supply hasn’t changed, the interest rate must adjust (rise)
to keep the money market in equilibrium. But R* doesn’t change, so interest rate
parity says that Y above Yf implies an expected $ depreciation. But such a
depreciation would drive us even further out of equilibrium, worsening the overheating. There would be no escape from this situation. This contradiction can only
be resolved if Y does not rise permanently after the fiscal policy move.
7. Policies and the current account
Since policymakers are often concerned with the current account (a political football), it
can be important to understand how monetary and fiscal policies affect the current
account.
To do so, we add one more line to the AA-DD graph, as shown in Fig. 16-17. Choose
some desired level (X) of CA. We can draw an XX schedule through all points where
CA(EP*/P, Y-T)=X.
This line slopes upward, since a rise in output leads to more spending on imports, so that
CA would worsen without currency depreciation. Alternatively, note that an increase in
E, all else equal, tends to make CA balance increase (see relevant equation), but an
increase in income can stimulate imports to cancel this out.
The main feature of this Figure is that the XX line is flatter than the DD line. Why?
Consider a movement along DD from point 1 to point 2, caused by monetary expansion.
Recall that total aggregate demand must equal supply along the DD line. But as we
increase Y in moving from point 1 to point 2, note that the domestic demand for domestic
output rises by less than the change in Y (increased spending on imports, increased
savings). To prevent an excess of domestic output supply, E must increase to cause
exports to increase more than imports. So net foreign demand must increase as output
rises along DD, so the CA improves along DD to the left of point 1 (and worsens on DD
to the right of point 1). Thus, the DD curve is steeper than the XX curve.
An increase in the money supply shifts AA to the left (point 2), so an increase in the
money supply improves the current account. A temporary fiscal expansion leads to point
3, below the XX line, so this worsens CA. A permanent fiscal expansion leads to point 4,
even further below the XX curve – expansionary fiscal policy worsens CA.
8. Trade flow adjustment and CA dynamics
Actual behavior underlying trade flows is much more complex than these models
suggest. The CA may adjust only slowly to exchange rate changes.
a) The J-Curve
Empirically, sometimes a country’s CA actually worsens after currency
devaluation. Why?
Sometimes effect of E on CA is speedy: the Mexican Peso devalued from Dec
94 to March 95 from 4 peso per $ to 6.5. The CA immediately rose from zero
balance (where it had been in the previous year to a surplus of $1.8 billion.
However, it may be that there is no real change in demand patterns and
volumes for a while – there is a lag due to contractual obligations and orders
having been placed months in advance. However, the effective price (in
domestic currency) paid for imports is immediately increased, while the price
(in domestic currency) received for exports is unchanged, there is an initial
fall in the CA, as seen in Fig. 16-18, from point 1 to point 2. It takes time for
new shipments to adjust fully (the upper dotted line) to the new relative prices.
The CA does not improve until point 3 (in time). This means that policies
may be less effective than as modeled.
b) Exchange rate pass-through
The short-run correspondence between the nominal and real exchange rates is
not so perfect in reality. While we have assumed that P* remains fixed when
E rises (so that the price of imports rises in proportion to the nominal change),
the actual percentage rise (after a 1% depreciation) is called the degree of
pass-through. This may be only incomplete.
Why? Well, there could be market segmentation and international price
discrimination (due to differing price elasticities, or differences in the degree
of competition in different markets). There is also an adjustment (menu) cost,
so firms may wait to see if the change is really a change or just a blip.
The link between nominal and real exchange rates is further weakened by
domestic price responses; an increase in aggregate demand from a nominal E
change may spark inflation. If P rises, the benefits to its competitive position
will be dissipated.