1、2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-1Chapter 16 OUTPUT AND THE EXCHANGE RATE IN THE SHORT RUNChapter 16 combines the theory of exchange rate determination with the theory of output determination in the short run. 2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-2In
2、troductionThe model developed in this chapter takes into account the fact that change exchange rates, interest rates and price levels may also affect output (i.e., output is endogenously determined). Therefore, it gives us a more complete picture of how macroeconomic changes affect an open economy.2
3、022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-3OverviewThe goods market and aggregate demandGoods market equilibrium: DD curveAsset market equilibrium: AA curveOverall equilibriumPolicy analysis with the model2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-4Determinants of A
4、ggregate Demand in an Open EconomyAggregate demandThe amount of a countrys goods and services demanded by households and firms throughout the world.D = C + I + G + CAFor simplicity, we assume that I and G are exogenously determined.2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-5Determi
5、nants of Consumption DemandConsumption demand increases as disposable income (i.e., national income less taxes) increases at the aggregate level.C = C(Yd), where Yd= Y T (Yd= disposable income), The increase in consumption demand is less than the increase in the disposable income because part of the
6、 income increase is saved.Determinants of Aggregate Demand in an Open Economy2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-6Determinants of the Current AccountThe CA balance is viewed as the demand for a countrys exports (EX) less that countrys own demand for imports (IM).The CA balanc
7、e is determined by two main factors: The domestic currencys real exchange rate against foreign currency (q = EP*/P) Domestic disposable income (Yd)CA=CA(q = EP*/P, Yd =Y T)Determinants of Aggregate Demand in an Open Economy2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-7How do changes i
8、n Disposable Income affect the Current Account?An increase in disposable income increases domestic consumers spending on all goods, including imports from abroad. That will lead to a decrease in the current account. Determinants of Aggregate Demand in an Open Economy2022-5-18 Lectured by Dr Jin Hong
9、feiDr Jin Hongfei Slide 16-8How do changes in the Real Exchange Rate affect the Current Account?It affects both exports and imports.An increase in q raises EX and improves the domestic countrys CA. Each unit of domestic output now purchases fewer units of foreign output, therefore, the foreign count
10、ry will demand more exports.Determinants of Aggregate Demand in an Open Economy2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-9However, an increase in q can raise or lower the value of imports measured in terms of domestic output.Therefore, the final effect of an increase in q on the cu
11、rrent account is AMBIGUOUS.Determinants of Aggregate Demand in an Open Economy2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-10There are two effects of a real exchange rate:Volume effect The effect of consumer spending shifts on export and import quantitiesValue effect It changes the do
12、mestic output worth of a given volume of foreign imports.Determinants of Aggregate Demand in an Open Economy2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-11Whether the CA improves or worsens depends on which effect of a real exchange rate change is dominant.We assume that the volume ef
13、fect of a real exchange rate change always outweighs the value effect.Determinants of Aggregate Demand in an Open Economy2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-12Assuming for now that the volume effect always outweighs the value effect, we have that: “other things equal, a real
14、depreciation of the currency improves the CA and a real appreciation of the currency worsens the CA”.As we will see later, this assumption requires that import and export demands be relatively elastic with respect to the real exchange rate (Marshall-Lerner Condition).Determinants of Aggregate Demand
15、 in an Open Economy2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-13Determinants of Aggregate Demand in an Open EconomyTable 16-1: Factors Determining the Current Account2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-14The four components of aggregate demand are combined to
16、 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)The Equation of Aggregate Demand2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-15The Real Exchange Rate and Aggregate Dem
17、andAn 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. Other things equal, a real depreciation of the home currency raises aggregate demand for home o
18、utput. Similarly, a real appreciation lowers aggregate demand for home output.The Equation of Aggregate Demand2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-16Real Income and Aggregate DemandA rise in domestic real income raises aggregate demand for home output.A fall in domestic real i
19、ncome lowers aggregate demand for home output.The Equation of Aggregate Demand2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-17Figure 16-1: Aggregate Demand as a Function of OutputOutput (real income), YAggregatedemand, DAggregate demand function,D(EP*/P, Y T, I, G)45The Equation of Agg
20、regate Demand2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-18How Output Is Determined in the Short RunOutput 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)2022-5-18 Lectured by Dr Jin Hongfei
21、Dr Jin Hongfei Slide 16-19Figure 16-2: The Determination of Output in the Short Run Output, YAggregatedemand, D45Aggregate demand = aggregate output, D = YAggregate demand2Y2D11Y13Y3How Output Is Determined in the Short Run2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-20How would a cha
22、nge in the nominal exchange rate affect 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
23、function and an expansion of output. Any fall in q will cause output to contract.Output Market Equilibrium in the Short Run: The DD Schedule2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-21Output Market Equilibrium in the Short Run: The DD Schedule Figure 16-3: Output Effect of a Curren
24、cy Depreciation with Fixed Output Prices Output, YAggregatedemand, D45D = Y1Y1Aggregate demand (E2)Aggregate demand (E1)Y22Currencydepreciates2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-22Deriving the DD ScheduleDD schedule It shows all combinations of output and the exchange rate fo
25、r 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. (If we assume that P and P* are fixed in the short run, a depreciation of the domestic currency is associated with a rise in Y. Sim
26、ilarly, an appreciation of the domestic currency is associated with a fall in output.)Output Market Equilibrium in the Short Run: The DD Schedule2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-23Y2DDOutput Market Equilibrium in the Short Run: The DD ScheduleFigure 16-4: Deriving the DD S
27、cheduleOutput, Y Aggregate demand, DD = YY1Aggregate demand (E2)Aggregate demand (E1)Y2Output, Y Exchange rate, EY11E1E222022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-24Factors that Shift the DD ScheduleGovernment purchasesTaxesInvestmentDomestic price levels Foreign price levelsDomest
28、ic consumptionDemand shift between foreign and domestic goodsA disturbance that raises (lowers) aggregate demand for domestic output shifts the DD schedule to the right (left).Output Market Equilibrium in the Short Run: The DD Schedule2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-25Y2O
29、utput Market Equilibrium in the Short Run: The DD ScheduleFigure 16-5: Government Demand and the Position of the DD ScheduleD = Y Y1D(E0P*/P, Y T, I, G2)D(E0P*/P, Y T, I, G1) Y2Output, Y Exchange rate, EY1Aggregate demand curves2Government spending risesOutput, Y Aggregate demand, DDD1E01DD22022-5-1
30、8 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-26AA ScheduleIt shows all combinations of exchange rate and output that are consistent with equilibrium in the domestic money market and the foreign exchange market.Asset Market Equilibrium in the Short Run: The AA Schedule2022-5-18 Lectured by Dr
31、Jin HongfeiDr Jin Hongfei Slide 16-27Output, the Exchange Rate, and Asset Market EquilibriumWe 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 =
32、R* + (Ee E)/Ewhere: Ee is the expected future exchange rateR is the interest rate on domestic currency depositsR* is the interest rate on foreign currency depositsAsset Market Equilibrium in the Short Run: The AA Schedule2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-28The R satisfying
33、the interest parity condition must also equate the real domestic money supply to aggregate real money demand: Ms/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 non-money assets less attractive to hold.Asset Market Equilibr
34、ium in the Short Run: The AA Schedule2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-29What are the effects of a rise in income (Y) on the nominal exchange rate (E)?Asset Market Equilibrium in the Short Run: The AA Schedule2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-30Ass
35、et Market Equilibrium in the Short Run: The AA ScheduleFigure 16-6: Output and the Exchange Rate in Asset Market EquilibriumDomestic-currency return on foreign-currency depositsForeignexchangemarketMoneymarket E22R2 E11R1Real moneysupplyMS P1L(R, Y2)L(R, Y1)Real domestic money holdingsDomestic inter
36、estrate, RExchange Rate, E02Output rises2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-31For 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 o
37、f the domestic currency.Asset Market Equilibrium in the Short Run: The AA Schedule2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-32Deriving the AA ScheduleIt relates exchange rates and output levels that keep the money and foreign exchange markets in equilibrium.It slopes downward becau
38、se a rise in output causes a rise in the home interest rate and a domestic currency appreciation.Asset Market Equilibrium in the Short Run: The AA Schedule2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-33Figure 16-7: The AA Schedule Output, Y Exchange Rate, EAsset Market Equilibrium in
39、the Short Run: The AA ScheduleAAY1E11Y2E222022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-34Factors that Shift the AA ScheduleDomestic money supplyDomestic price levelExpected future exchange rateForeign interest rateShifts in the aggregate real money demand scheduleAsset Market Equilibr
40、ium in the Short Run: The AA Schedule2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-35Factors that Shift the AA ScheduleIn general, if the change leads to an increase in the nominal exchange rate (currency depreciation), the AA curve shifts to the right. If the change leads to a fall in
41、 E (currency appreciation), AA shifts to the left.Asset Market Equilibrium in the Short Run: The AA Schedule2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-36Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules TogetherA short-run equilibrium for the economy as a wh
42、ole must bring equilibrium simultaneously in the output and asset markets.That is, it must lie on both DD and AA schedules.2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-37Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules TogetherOutput prices are fixed (P and P
43、*)Also R* and Ee are fixed.The intersection of the DD curve and the AA curve is the only combination of E and Y that is consistent both with equilibrium in the market for goods & services and with equilibrium in the money market.2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-38Figure 16
44、-8: Short-Run Equilibrium: The Intersection of DD and AA Output, Y Exchange Rate, EAAY1E11Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules TogetherDD2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-39Figure 16-9: How the Economy Reaches Its Short-Run EquilibriumA
45、AY1E11Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules TogetherDD3E32E2 Output, Y Exchange Rate, E2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-40Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules TogetherHow does the economy reach its
46、short-run equilibrium?Assets markets adjust quickly: the exchange rate moves from E2 to E3 immediately.The economy then moves to point 1 along the AA curve as output rises to meet aggregate demand.2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-41Temporary Changes in Monetary and Fiscal
47、PolicyTwo 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
48、 exchange rate.Assume that policy shifts do not influence the foreign interest rate and the foreign price level.2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-42Monetary PolicyAn increase in money supply (i.e., expansionary monetary policy) raises the economys output. The increase in mo
49、ney 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.Temporary Changes in Monetary and Fiscal Policy2022-5-18 Lectured by
50、Dr Jin HongfeiDr Jin Hongfei Slide 16-43DDFigure 16-10: Effects of a Temporary Increase in the Money Supply Output, Y Exchange Rate, EAA2Y2E22AA11E1Y1Temporary Changes in Monetary and Fiscal Policy2022-5-18 Lectured by Dr Jin HongfeiDr Jin Hongfei Slide 16-44Fiscal PolicyAn increase in government sp
