Transcript Ch. 16: Output and the Exchange Rate in the Short Run.

Ch. 16: Output and the
Exchange Rate in the Short Run
The Plan
Total expenditures (aggregate demand)
will respond to Y, q, I, G, T.
 Monetary sector will determine R and
nominal exchange rate.
 In the short run Y changes and impacts
the money demand.
 The effects of policy changes on the
equilibrium values will be investigated.

Aggregate Demand
In the long run, the output Y of an
economy is determined with the
combination of labor, capital and
technology fully employed.
 In the short run, however, output is
determined by the level of aggregate
demand.
 Aggregate demand is C+I+G+CA.

Determinants of Consumption
Consumption is a function of disposable
income.
 Yd = Y - T
 C = Yd - S
 MPC = DC/DYd < 1.
 C = C (Yd)

Determinants of CA
CA = EX - IM
 CA = CA(q,Yd)
 q$/¥ = ($/¥)(P¥/P$)
 q$/¥ = E(P*/P)
 If P* is the cost of a typical basket in
Japan and P is the cost of a typical
basket in USA.
 Real exchange rate is the US basket
per Japanese basket.

Real Exchange Rate to EX
When real exchange rate q$/¥ = ($/¥)(P¥/P$)
rises, foreign products become more
expensive relative to domestic products.
 Each unit of domestic basket purchases
fewer units of foreign basket.
 US basket per Japanese basket has
increased.
 Japanese will be more willing to buy US
products because the opportunity cost is
lower now: EX goes up.

Real Exchange Rate to IM
When real exchange rate q$/¥ = ($/¥)(P¥/P$)
rises, domestic consumers will purchase
fewer units of the more expensive foreign
products.
 But imports in the aggregate demand
stipulation (C+I+G+EX-IM) is in terms of
domestic real income, or domestic output
units.
 Since more domestic output units may have
to be sacrificed for fewer foreign products,
IM may increase or decrease as a result of

Real Exchange Rate and CA
As q increases, EX goes up.
 As q increases, IM may go down or up.
 Assuming that the volume effect on IM
dominates the value effect, we can
conclude that q increase will result in
CA increase.
 A real appreciation of the yen will
increase US current account.

Disposable Income and CA
An increase in disposable income will
increase consumption expenditures.
 Some of the consumption expenditures
are on imports.
 An increase in disposable income,
therefore, will worsen the current
account.

Variables of Aggregate
Demand
1. Aggregate
demand is
AD = C + I + G + CA
1. C
is dependent on disposable income
C = C(Y-T)
1. CA
is dependent on real exchange rate and
disposable income
CA = CA(q$/¥ , Y-T)
1. Assuming
I and G are given (exogenous),
aggregate demand will be determined by
q,Y-T, I, and G.
A Caveat
The full model should include
determinants of I (real interest rate) and
S (real interest rate and disposable
income).
 Of course, the impact of monetary
sector on interest rates and exchange
rates will need to be developed, too.
That will come later.
 Now we analyze the impact of the
stipulated variables on aggregate
demand.

Real Exchange Rate
A rise in real exchange rate, q$/¥ =
($/¥)(P¥/P$), makes domestic goods
cheaper relative to Japanese goods.
 US exports increase and US imports
(may) decrease.
 CA rises, raising the aggregate
demand.

Real Income
If taxes are constant, an increase in real
income (Y) will raise consumption and
worsen CA.
 Taxes usually respond to Y, so they need
not be constant, but let’s assume they are.
 Typically, because of nontraded goods, a
higher portion of the consumption increase
will go to domestic output rather than
imports.
 The domestic consumption effect of income
increase will exceed the import effect and Y
increase will raise AD.

Real Income and Aggregate
Demand

A unit increase in real income will not
increase consumption of domestic
output by the same unit because
some of the increase will go to imports.
 Some of the increase will go to savings.
 If taxes respond to income, some of the
increase will go to taxes.


Aggregate demand as a function of real
income Y will have a slope less than
one.
Equilibrium in the Output
Market
Aggregate supply is the output
produced (Y).
 Equilibrium requires AD = AS.
 If we draw AD as a function of Y, then
equilibrium will only take place when Y
= AD, or along the 45 degree line.
 This analysis holds in the short run, that
is output adjusts to bring equilibrium
because we kept prices constant in the
short run.

Equilibrium in the Short Run
AD
At Y1, AD>Y. Firms
respond to excess demand
by increasing output,
bringing the system toward
Y*.
At Y2, Y>AD. Firms
respond to excess supply
by reducing production,
bringing the system toward
Y*.
AD=Y
AD
Y1
Y*
Y2
Y
Real Exchange Rate
A rise in the real exchange rate, q$/¥ =
($/¥)(P¥/P$), can occur either by
nominal appreciation of yen or rise in
Japanese price level or drop in US price
level.
 All of these will make US products
cheaper and will give a boost to CA.
 Higher CA will translate into higher AD.

Equilibrium with q Change
AD
AD=Y
AD’
AD
A rise in q$/¥ , real
depreciation of USD, will
improve CA and increase
AD.
Equilibrium will take
place at the higher Y2.
Y1
Y2
Y
Nominal Exchange Rates and
Output Equilibrium
In the short run both Japanese and US
price levels will remain constant.
 A nominal appreciation of the yen will
translate as a real appreciation of the yen.
 The relationship between the nominal
exchange rate and the short run
equilibrium of the output will comprise the
DD curve.

Nominal Exchange Rates and
Output Equilibrium
AD
Y
$/¥
DD
Y
Short run equilibrium, given
exchange rates takes place at the
intersection of white lines.
When E rises, ¥ appreciates and $
depreciates, CA improves and AD
increases.
The new equilibrium takes place at
the blue Y level, corresponding to
blue nominal exchange rate.
Shifts of DD Schedule

Any change in variables that will force
the AD curve to shift will also shift the
DD curve in the same direction.


Exception is a change in the nominal
exchange rate; that change will be a
movement along the DD curve.
All other forces that will change C, I, G,
CA will shift the DD curve.
Shifts in DD Schedule
An increase in C or G or I or foreign
price level, ceteris paribus, will all shift
the AD upwards and DD to the right.
AD
Y
Likewise, a decrease in T or domestic
price level, ceteris paribus, will all shift
the AD upwards and DD to the right.
$/¥
Of course, AD would shift down and
DD to the left if the variables changed
in the opposite direction.
DD
In all cases, $/¥ is kept constant.
Y
Asset Market Equilibrium in
the Short Run
We will trace the required nominal exchange
rate and real income to keep that will satisfy
interest parity and monetary sector
equilibrium.
 Interest parity
R = R* + (Ee - E)/E
 Monetary equilibrium
Ms/P = L(R,Y)

Asset Market Equilibrium
R
R
R
M/P
Y up => real money
demand up => R up
=> E down (USD
appreciates)
AA shows the asset
market equilibrium.
$/¥
AA
E1
E2
R
Y1
Y2
Ms Decrease or P Increase
R
R
R
M/P
$/¥
Money supply decrease
or P increase raises R.
At the same output level,
$ appreciates and AA
shifts left.
AA
E1
E2
R
Y1
A Rise in Ee or R*
R
R
R
M/P
An increase in the
expected dollar returns
from yen deposits
raises the exchange
rate (yen appreciates).
AA shifts right.
$/¥
E2
AA
E1
R
Y1
Equilibrium in Output and
Asset Markets
$/¥
Unless the exchange
rate and output
combination falls on
AA, the asset market
will be out of
equilibrium. Likewise,
if the combination is
away from DD, the
output market will be
out of equilibrium.
1
DD
2
AA
Y
Point 1 implies $ returns
on yen deposits have to be
higher. If they are not,
there will be flight from
yen into $: E will fall.
At 2 asset market is in
equilibrium but output
market isn’t. AD>AS.
Firms increase production
to meet excess demand.
Temporary Ms Increase
R
R
Temporary means
the public expects
the reversal of the
policy in the future.
R
M/P
Ms up => R down => $
depreciates => CA
improves => Y increases
=> real money demand
rises => R increases =>
E falls ($ appreciates).
$/¥
AA
E2
E1
R
Y1
Temporary G Increase or T
Decrease
A one time increase in G raises Y. AD and DD
both shift to the blue lines. Even though the
output market is in equilibrium, the higher
income has raised the R and made $ more
attractive.
AD
Y
$/¥
DD
AA
Y
As funds flow into $, E falls
(yen depreciates). The fall of E makes
Japanese products cheaper. US CA falls
and AD adjusts. Both markets reach
equilibrium along the brick lines.
Full Employment Policies for a
Fall in Demand for Domestic
Products
E
DD
Fiscal expansion
Monetary expansion
E1
AA
Y1
Full Employment Policies for a
Rise in Money Demand
E
DD
E1
Fiscal expansion
Monetary expansion
AA
Y1
Permanent Shifts
A permanent change in fiscal and
monetary policy affects the long run
exchange rate.
 Because permanent changes affect
expectations, they affect the current
exchange rates, as well.
 In the following examples, we will
assume that the economy starts at full
employment with expected exchange
rate equal to current exchange rate, or
R=R*.

Permanent Ms Increase
R
R
The expected E rise
($ depreciation)
makes the return
curve shift and
depreciate the $
even more.
R
M/P
Ms up => R down => $
depreciates => CA
improves => Y increases
=> real money demand
rises => R increases =>
E falls ($ appreciates).
$/¥
DD
AA
E2
E1
R
Y1
Permanent Ms Increase
The economy started at full employment
at Y1.
 Higher money supply moved the
economy to above Y1.
 As the price level adjusts to the higher
money supply two things happen:

The real money supply falls shifting AA to
the left.
 Real appreciation of $ lowers CA and DD.

Permanent Ms Increase
R
R
R
M/P
Price level increase
shifts both DD and
AA to the left. Higher
price level shifts real
money supply to the
left. Lower Y shifts
real money demand
to the left.
$/¥
DD
AA
E3
E2
E1
R
Y1
Permanent Fiscal Expansion
P and M are constant;
R doesn’t change. Gov.
purchases increase the
demand for US output
and appreciate $ in the
long run. DG = -DCA.
AD
$/¥
DD
AA
R
Y1
Y
XX Curve
E
DD
XX
AA
Y
XX shows a constant value of CA. To
the right of the intersection, as Y
increases, to have AS=AD, $ has to
depreciate a lot to compensate for the
increased imports and increased savings
to eliminate any excess supply. This
means CA turns positive along DD.
To the left of the intersection, CA turns
negative along DD.
Monetary expansion, therefore, moves
CA toward surplus.
Fiscal expansion moves CA toward
deficit.