A Short-Run Model of an Open Economy1 BA 282 Macroeconomics Class Notes - Part 4

A Short-Run Model of an Open Economy 1

A Short-Run Model of an Open Economy

BA 282

Macroeconomics

Class Notes - Part 4


Aggregate Demand

Aggregate demand (D) is the amount of a country’s goods and services demanded by households and firms throughout the world Recall GDP = C + I + G + EX - IM = D Each of these components has various sources that

determine demand for that factor We will concentrate here on consumption and CA Specifically, let’s assume

C = C(YD)

and

CA = CA(E, YD)


Aggregate Demand and CA To see how a change in E effects CA we look at EX

and IM Separately. Assume an increase in E This results in an increase in EX since domestic goods

look cheaper to foreigners This can result in an increase or decrease in IM. Why?

(for now assume an increase in E results in a decrease of IM)

An increase in YD will decrease CA. Why?


Aggregate Demand

We can now write a more general function for D

D = C(Y-T) + I + G + CA(E , Y-T)

where

Consumption demand (C) is a function of YD

YD = Y - T (T = aggregate taxes)

or more generally

D = D(E , Y-T, I, G)


Aggregate demand Let’s review

D = D(E , Y-T, I, G)

Increasing the real exchange rate increases D through the current account

Increasing income will increase D through increases in consumption demand decrease D through increasing import demand The consumption demand effect will be greater then the import

demand effect so an increase in income will increase aggregate demand

Increasing investment demand I increases D Increasing government demand G increases D


Aggregate Demand and OutputAggregate Demand (D)

Real Income (Y)

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Aggregate DemandD(E ,Y-T, I, G)


Equilibrium in the Output Market

Equilibrium in the domestic output market will occur when aggregate demand equals output (real income)

In the short-run we consider prices fixed

In the long-run prices will adjust


Equilibrium in the Output MarketAggregate Demand (D)

Output (Y)

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Aggregate DemandD(E ,Y-T, I, G)

Aggregate Demand (D) = Aggregate Output (Y)

Y1Y2 Y3

D1

D2

D3

1

2

3


The DD Schedule Now we need to derive the relationship between

the exchange rate and output (the DD schedule) when the output market is in equilibrium

To do this consider an increase in the nominal exchange rate from E1 to E2

This will increase aggregate demand. Why?


Equilibrium Output after Currency Depreciation

Aggregate Demand (D)

Output (Y)

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Aggregate DemandD(E1 ,Y-T, I, G)

Y1 Y2

D1

D2

1

2

Aggregate DemandD(E2 ,Y-T, I, G)

Currency Depreciation


Deriving the DD Schedule By noting the short-run equilibrium level in the

output market for all levels of the nominal exchange rate we derive the DD schedule

Intuitively, the DD schedule allows us to see how short-run fluctuations in the nominal exchange rate impact aggregate domestic demand


Deriving the DD Schedule

D

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Y1 Y2

D1

D2

1

2

D(E2)

D(E1)

Nominal Exchange Rate (E)

Y1 Y2

E1

E2

1

2

Output

DD


What Factors Shift the DD Curve? Recall where the DD curve comes from

D(E ,Y-T, I, G) So all of the following can shift the DD curve

Disposable income Investment Government spending (and taxes) The consumption function A demand shift between foreign and domestic

consumption


Example: Increase in Government Spending


Y1 Y2

1 2

DD1 DD2

E0

Output


The AA Schedule The AA schedule relates exchange rates and output levels

that keep the money and foreign exchange (asset) markets in equilibrium

We start with the interest parity condition (with RFC and Ee held constant),

RLC = RFC + (Ee-E)/E

and the equilibrium money market equation

MS/PLC = L(RLC,Y)

Now recall money and exchange rate market equilibrium from chapter 14 and an increase in output (Y)


The AA Schedule


The AA ScheduleSo in the short run, an increase in output decreases the exchange rate


Y1 Y2

1

2

AA

E1

Output

E2


The AA Schedule The AA schedule describes how exchange rates fall as

output increases Changes in output will result in a movement along this curve

Anything that changes the stacked graphs – the foreign exchange market and money market – except output will shift the curve A change in MS for a fixed level of Y A change in Ee

A change in the foreign interest rate RFC

A change in the real money demand function L(RLC, Y)


Short-Run Equilibrium We now have separate models for exchange-rate

equilibrium in the Output market (the DD schedule) Asset market (the AA schedule)

We can combine these to get a short-run equilibrium for the whole economy This will be the intersection of the AA and DD schedules

To see why this is the equilibrium consider an exchange rate above the AA schedule and on the left of the DD schedule


Short-Run equilibrium


Y1

1

2

AA

E2

Output

E1

DD

3E3


Applications of DD-AA Model Now that we have a general model of short-run

equilibrium we can use it to explore the impact of various economic changes such as

Changes in fiscal and monetary policy

Changes in world demand for domestic products

Changes in money-demand


Monetary Policy How does a temporary increase in the domestic money

supply affect the equilibrium of an open economy?

E

Y1

1

2

AA1

E2

Output

E1

DD

Y2

AA2


Fiscal Policy How does a temporary fiscal expansion (higher G and/or

lower T) affect the equilibrium of an open economy?

E

Y1

1

2

AA

E2

Output

E1

DD1

Y2

DD2


Fall in World Demand for Domestic Products How can monetary policy be used to restore the economy to its full-employment

output level after a decline in the world demand for domestic products?

E

Yf

1

2

AA1

E3

Output

E1

DD1

Y2

DD2

3

E2

AA2

Drop in World Demand

Monetary Expansion

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A Short-Run Model of an Open Economy1 BA 282 Macroeconomics Class Notes - Part 4