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Chapter 16

Output and the Exchange Rate in the Short Run

Prepared by Iordanis Petsas

To Accompany

International Economics: Theory and Policy, Sixth Edition

by Paul R. Krugman and Maurice Obstfeld

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Chapter Organization

Determinants of Aggregate Demand in an Open Economy
The Equation of Aggregate Demand
How Output Is Determined in the Short Run
Output Market Equilibrium in the Sort Run: The DD Schedule
Asset Market Equilibrium in the Short Run: The AA Schedule
Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together

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Chapter Organization

Temporary Changes in Monetary and Fiscal Policy
Inflation Bias and Other Problems of Policy Formulation
Permanent Shifts in Monetary and Fiscal Policy
Macroeconomic Policies and the Current Account
Gradual Trade Flow Adjustment and Current Account Dynamics
Summary

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Chapter Organization

Appendix I: The IS-LM Model and the DD-AA Model
Appendix II: Intertemporal Trade and Consumption Demand
Appendix III: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities

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Introduction

Macroeconomic changes that affect exchange rates, interest rates, and price levels may also affect output.

This chapter introduces a new theory of how the output market adjusts to demand changes when product prices are themselves slow to adjust.

A short-run model of the output market in an open economy will be utilized to analyze:

The effects of macroeconomic policy tools on output and the current account
The use of macroeconomic policy tools to maintain full employment

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Determinants of Aggregate �Demand in an Open Economy

Aggregate demand

The amount of a country’s goods and services demanded by households and firms throughout the world.

The aggregate demand for an open economy’s output consists of four components:

Consumption demand (C)
Investment demand (I)
Government demand (G)
Current account (CA)

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Determinants of Aggregate �Demand in an Open Economy

Determinants of Consumption Demand

Consumption demand increases as disposable income (i.e., national income less taxes) increases at the aggregate level.

The increase in consumption demand is less than the increase in the disposable income because part of the income increase is saved.

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Determinants of Aggregate �Demand in an Open Economy

Determinants of the Current Account

The CA balance is viewed as the demand for a country’s exports (EX) less that country's own demand for imports (IM).
The CA balance is determined by two main factors:

The domestic currency’s real exchange rate against foreign currency (q = EP*/P)
Domestic disposable income (Y^d)

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Determinants of Aggregate �Demand in an Open Economy

How Real Exchange Rate Changes Affect the Current Account

An increase in q raises EX and improves the domestic country’s CA.

Each unit of domestic output now purchases fewer units of foreign output, therefore, foreign will demand more exports.

An increase q can raise or lower IM and has an ambiguous effect on CA.

IM denotes the value of imports measured in terms of domestic output.

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Determinants of Aggregate �Demand in an Open Economy

There are two effects of a real exchange rate:

Volume effect

The effect of consumer spending shifts on export and import quantities

Value effect

It changes the domestic output worth of a given volume of foreign imports.

Whether the CA improves or worsens depends on which effect of a real exchange rate change is dominant.
We assume that the volume effect of a real exchange rate change always outweighs the value effect.

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Determinants of Aggregate �Demand in an Open Economy

How Disposable Income Changes Affect the Current Account

An increase in disposable income (Y^d) worsens the CA.
A rise in Y^dcauses domestic consumers to increase their spending on all goods.

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Determinants of Aggregate �Demand in an Open Economy

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Table 16-1: Factors Determining the Current Account

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The Equation of Aggregate Demand

The four components of aggregate demand are combined to get the total aggregate demand:

D = C(Y – T) + I + G + CA(EP*/P, Y – T)

This equation shows that aggregate demand for home output can be written as:

D = D(EP*/P, Y – T, I, G)

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The Equation of Aggregate Demand

The Real Exchange Rate and Aggregate Demand

An increase in q raises CA and D.

It makes domestic goods and services cheaper relative to foreign goods and services.
It shifts both domestic and foreign spending from foreign goods to domestic goods.
A real depreciation of the home currency raises aggregate demand for home output.

A real appreciation lowers aggregate demand for home output.

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The Equation of Aggregate Demand

Real Income and Aggregate Demand

A rise in domestic real income raises aggregate demand for home output.
A fall in domestic real income lowers aggregate demand for home output.

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The Equation of Aggregate Demand

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Figure 16-1: Aggregate Demand as a Function of Output

Output (real income), Y

Aggregate

demand, D

Aggregate demand function,

D(EP*/P, Y – T, I, G)

45°

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How Output Is �Determined in the Short Run

Output market is in equilibrium in the short-run when real output, Y, equals the aggregate demand for domestic output:

Y = D(EP*/P, Y – T, I, G) (16-1)

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How Output Is �Determined in the Short Run

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Figure 16-2: The Determination of Output in the Short Run

Output, Y

Aggregate

demand, D

45°

Aggregate demand =

aggregate output, D = Y

Aggregate demand

Y²

D¹

Y¹

Y³

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Output Market Equilibrium in the Short Run: The DD Schedule

Output, the Exchange Rate, and Output Market Equilibrium

With fixed price levels at home and abroad, a rise in the nominal exchange rate makes foreign goods and services more expensive relative to domestic goods and services.

Any rise in q will cause an upward shift in the aggregate demand function and an expansion of output.
Any fall in q will cause output to contract.

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Output Market Equilibrium in the Short Run: The DD Schedule

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Figure 16-3: Output Effect of a Currency Depreciation with Fixed Output Prices

Output, Y

Aggregate

demand, D

45°

D = Y

Y¹

Aggregate demand (E²)

Aggregate demand (E¹)

Y²

Currency

depreciates

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Output Market Equilibrium in the Short Run: The DD Schedule

Deriving the DD Schedule

DD schedule

It shows all combinations of output and the exchange rate for which the output market is in short-run equilibrium (aggregate demand = aggregate output).
It slopes upward because a rise in the exchange rate causes output to rise.

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Output Market Equilibrium in the Short Run: The DD Schedule

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Y²

Figure 16-4: Deriving the DD Schedule

Output, Y

Aggregate demand, D

D = Y

Y¹

Aggregate demand (E²)

Aggregate demand (E¹)

Y²

Output, Y

Exchange rate, E

Y¹

E¹

E²

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Output Market Equilibrium in the Short Run: The DD Schedule

Factors that Shift the DD Schedule

Government purchases
Taxes
Investment
Domestic price levels
Foreign price levels
Domestic consumption
Demand shift between foreign and domestic goods

A disturbance that raises (lowers) aggregate demand for domestic output shifts the DD schedule to the right (left).

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Output Market Equilibrium in the Short Run: The DD Schedule

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Y²

Figure 16-5: Government Demand and the Position of the DD Schedule

D = Y

Y¹

D(E⁰P*/P, Y – T, I, G²)

D(E⁰P*/P, Y – T, I, G¹)

Y²

Output, Y

Exchange rate, E

Y¹

Aggregate demand curves

Government

spending rises

Output, Y

Aggregate demand, D

DD¹

E⁰

DD²

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Asset Market Equilibrium in the Short Run: The AA Schedule

AA Schedule

It shows all combinations of exchange rate and output that are consistent with equilibrium in the domestic money market and the foreign exchange market.

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Asset Market Equilibrium in the Short Run: The AA Schedule

Output, the Exchange Rate, and Asset Market Equilibrium

We will combine the interest parity condition with the money market to derive the asset market equilibrium in the short-run.
The interest parity condition describing foreign exchange market equilibrium is:

R = R* + (E^e – E)/E

where: E^e is the expected future exchange rate

R is the interest rate on domestic currency deposits

R^* is the interest rate on foreign currency deposits

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Asset Market Equilibrium in the Short Run: The AA Schedule

The R satisfying the interest parity condition must also equate the real domestic money supply to aggregate real money demand:

M^s/P = L(R, Y)

Aggregate real money demand L(R, Y) rises when the interest rate falls because a fall in R makes interest-bearing nonmoney assets less attractive to hold.

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Asset Market Equilibrium in the Short Run: The AA Schedule

Figure 16-6: Output and the Exchange Rate in Asset Market Equilibrium

Domestic-currency

return on foreign-

currency deposits

Foreign

exchange

market

Money

market

E²

R²

E¹

R¹

Real money

supply

M^S

L(R, Y²)

L(R, Y¹)

Real domestic money holdings

Domestic interest

rate, R

Exchange Rate, E

Output rises

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For asset markets to remain in equilibrium:

A rise in domestic output must be accompanied by an appreciation of the domestic currency.
A fall in domestic output must be accompanied by a depreciation of the domestic currency.

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Asset Market Equilibrium in the Short Run: The AA Schedule

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Deriving the AA Schedule

It relates exchange rates and output levels that keep the money and foreign exchange markets in equilibrium.
It slopes downward because a rise in output causes a rise in the home interest rate and a domestic currency appreciation.

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Asset Market Equilibrium in the Short Run: The AA Schedule

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Figure 16-7: The AA Schedule

Output, Y

Exchange

Rate, E

Asset Market Equilibrium in the Short Run: The AA Schedule

Y¹

E¹

Y²

E²

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Factors that Shift the AA Schedule

Domestic money supply
Domestic price level
Expected future exchange rate
Foreign interest rate
Shifts in the aggregate real money demand schedule

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Asset Market Equilibrium in the Short Run: The AA Schedule

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Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together

A short-run equilibrium for the economy as a whole must bring equilibrium simultaneously in the output and asset markets.

That is, it must lie on both DD and AA schedules.

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Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together

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Figure 16-8: Short-Run Equilibrium: The Intersection of DD and AA

Output, Y

Exchange

Rate, E

Y¹

E¹

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Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together

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Figure 16-9: How the Economy Reaches Its Short-Run Equilibrium

Y¹

E¹

E³

E²

Output, Y

Exchange

Rate, E

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Temporary Changes �in Monetary and Fiscal Policy

Two types of government policy:

Monetary policy

It works through changes in the money supply.

Fiscal policy

It works through changes in government spending or taxes.

Temporary policy shifts are those that the public expects to be reversed in the near future and do not affect the long-run expected exchange rate.
Assume that policy shifts do not influence the foreign interest rate and the foreign price level.

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Temporary Changes �in Monetary and Fiscal Policy

Monetary Policy

An increase in money supply (i.e., expansionary monetary policy) raises the economy’s output.

The increase in money supply creates an excess supply of money, which lowers the home interest rate.

As a result, the domestic currency must depreciate (i.e., home products become cheaper relative to foreign products) and aggregate demand increases.

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Temporary Changes �in Monetary and Fiscal Policy

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Figure 16-10: Effects of a Temporary Increase in the Money Supply

Output, Y

Exchange

Rate, E

AA²

Y²

E²

AA¹

E¹

Y¹

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Temporary Changes �in Monetary and Fiscal Policy

Fiscal Policy

An increase in government spending, a cut in taxes, or some combination of the two (i.e, expansionary fiscal policy) raises output.

The increase in output raises the transactions demand for real money holdings, which in turn increases the home interest rate.

As a result, the domestic currency must appreciate.

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Temporary Changes �in Monetary and Fiscal Policy

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DD¹

Figure 16-11: Effects of a Temporary Fiscal Expansion

Output, Y

Exchange

Rate, E

DD²

Y¹

E¹

Y²

E²

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Temporary Changes �in Monetary and Fiscal Policy

Policies to Maintain Full Employment

Temporary disturbances that lead to recession can be offset through expansionary monetary or fiscal policies.

Temporary disturbances that lead to overemployment can be offset through contractionary monetary or fiscal policies.

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Temporary Changes �in Monetary and Fiscal Policy

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Figure 16-12: Maintaining Full Employment After a Temporary Fall in World Demand for Domestic Products

Output, Y

Exchange

Rate, E

DD¹

AA²

AA¹

Y^f

Y²

E²

DD²

E¹

E³

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Temporary Changes �in Monetary and Fiscal Policy

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DD¹

Figure 16-13: Policies to Maintain Full Employment After

a Money-Demand Increase

Output, Y

Exchange

Rate, E

DD²

AA¹

AA²

Y^f

Y²

E²

E³

E¹

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Inflation Bias and Other �Problems of Policy Formulation

Problems of policy formulation:

Inflation bias

High inflation with no average gain in output that results from governments’ policies to prevent recession

Identifying the sources of economic changes
Identifying the durations of economic changes
The impact of fiscal policy on the government budget
Time lags in implementing policies

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Permanent Shifts in �Monetary and Fiscal Policy

A permanent policy shift affects not only the current value of the government’s policy instrument but also the long-run exchange rate.

This affects expectations about future exchange rates.

A Permanent Increase in the Money Supply

A permanent increase in the money supply causes the expected future exchange rate to rise proportionally.

As a result, the upward shift in the AA schedule is greater than that caused by an equal, but transitory, increase (compare point 2 with point 3 in Figure 16-14).

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Permanent Shifts in �Monetary and Fiscal Policy

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DD¹

Figure 16-14: Short-Run Effects of a Permanent Increase in the Money Supply

Output, Y

Exchange

Rate, E

AA²

Y²

E²

AA¹

E¹

Y^f

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Permanent Shifts in �Monetary and Fiscal Policy

Adjustment to a Permanent Increase in the Money Supply

The permanent increase in the money supply raises output above its full-employment level.

As a result, the price level increases to bring the economy back to full employment.

Figure 16-15 shows the adjustment back to full employment.

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Permanent Shifts in �Monetary and Fiscal Policy

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DD²

Figure 16-15: Long-Run Adjustment to a Permanent Increase in the Money Supply

Output, Y

Exchange

Rate, E

DD¹

AA²

AA³

Y^f

E³

AA¹

Y²

E²

E¹

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Permanent Shifts in �Monetary and Fiscal Policy

A Permanent Fiscal Expansion

A permanent fiscal expansion changes the long-run expected exchange rate.

If the economy starts at long-run equilibrium, a permanent change in fiscal policy has no effect on output.

It causes an immediate and permanent exchange rate jump that offsets exactly the fiscal policy’s direct effect on aggregate demand.

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Permanent Shifts in �Monetary and Fiscal Policy

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DD¹

Figure 16-16: Effects of a Permanent Fiscal Expansion Changing the Capital Stock

Output, Y

Exchange

Rate, E

DD²

AA¹

AA²

Y^f

E²

E¹

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Macroeconomic Policies� and the Current Account

XX schedule

It shows combinations of the exchange rate and output at which the CA balance would be equal to some desired level.
It slopes upward because a rise in output encourages spending on imports and thus worsens the current account (if it is not accompanied by a currency depreciation).
It is flatter than DD.

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Macroeconomic Policies� and the Current Account

Monetary expansion causes the CA balance to increase in the short run (point 2 in Figure 16-17).
Expansionary fiscal policy reduces the CA balance.

If it is temporary, the DD schedule shifts to the right (point 3 in Figure 16-17).
If it is permanent, both AA and DD schedules shift (point 4 in Figure 16-17).

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Macroeconomic Policies� and the Current Account

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Figure 16-17: How Macroeconomic Policies Affect the Current Account

Output, Y

Exchange

Rate, E

Y^f

E¹

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Gradual Trade Flow Adjustment �and Current Account Dynamics

The J-Curve

If imports and exports adjust gradually to real exchange rate changes, the CA may follow a J-curve pattern after a real currency depreciation, first worsening and then improving.

Currency depreciation may have a contractionary initial effect on output, and exchange rate overshooting will be amplified.

It describes the time lag with which a real currency depreciation improves the CA.

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Gradual Trade Flow Adjustment �and Current Account Dynamics

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Figure 16-18: The J-Curve

Time

Current account (in

domestic output units)

Long-run

effect of real

depreciation

on the current

account

Real depreciation takes place and J-curve begins

End of J-curve

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Gradual Trade Flow Adjustment �and Current Account Dynamics

Exchange Rate Pass-Through and Inflation

The CA in the DD-AA model has assumed that nominal exchange rate changes cause proportional changes in the real exchange rates in the short run.
Degree of Pass-through

It is the percentage by which import prices rise when the home currency depreciates by 1%.

In the DD-AA model, the degree of pass-through is 1.

Exchange rate pass-through can be incomplete because of international market segmentation.

Currency movements have less-than-proportional effects on the relative prices determining trade volumes.

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Summary

The aggregate demand for an open economy’s output consists of four components: consumption demand, investment demand, government demand, and the current account.
Output is determined in the short run by the equality of aggregate demand and aggregate supply.
The economy’s short-run equilibrium occurs at the exchange rate and output level.

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Summary

A temporary increase in the money supply causes a depreciation of the currency and a rise in output.
Permanent shifts in the money supply cause sharper exchange rate movements and therefore have stronger short-run effects on output than transitory shifts.
If exports and imports adjust gradually to real exchange rate changes, the current account may follow a J-curve pattern after a real currency depreciation, first worsening and then improving.

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Appendix I: The IS-LM Model �and the DD-AA Model

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Figure 16AI-1: Short-Run Equilibrium in the IS-LM Model

Output, Y

Interest

rate, R

Y¹

R¹

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R²

Figure 16AI-2: Effects of Permanent and Temporary Increases in the Money Supply in the IS-LM Model

Appendix I: The IS-LM Model

and the DD-AA Model

R³

LM²

Output, Y

Interest rate, R

LM¹

Y³

Y²

Y¹

R¹

3´

E³

1´

E¹

E²

2´

Exchange rate, E (← increasing)

Expected

domestic-currency

return on

foreign-currency

deposits

IS¹

IS²

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R²

Figure 16AI-3: Effects of Permanent and Temporary Fiscal Expansions in the IS-LM Model

Appendix I: The IS-LM Model and the DD-AA Model

R¹

Output, Y

Interest rate, R

Y^f

Y²

2´

E²

Exchange rate, E (← increasing)

Expected

domestic-currency

return on

foreign-currency

deposits

E¹

1´

E³

3´

IS¹

IS²

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Appendix II: Intertemporal Trade and Consumption Demand

Present

consumption

Future

consumption

D¹_P = Q¹_P

Figure 16AII-1: Change in Output and Saving

Indifference

curves

Intertemporal

budget constraints

Intertemporal

budget constraints

D²_P

2´

Q²_P

D¹_F = Q¹_F

D²_F

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Appendix III: The Marshall-Lerner Condition

and Empirical Estimates of Trade Elasticities

Table 16AIII-1: Estimated Price Elasticities for International Trade

in Manufactured Goods