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

The PlanThe PlanTotal expenditures (aggregate demand) Total expenditures (aggregate demand)

will respond to Y, q, I, G, T.will respond to Y, q, I, G, T.Monetary sector will determine R and Monetary sector will determine R and

nominal exchange rate.nominal exchange rate. In the short run Y changes and impacts In the short run Y changes and impacts

the money demand.the money demand.The effects of policy changes on the The effects of policy changes on the

equilibrium values will be investigated.equilibrium values will be investigated.

Aggregate DemandAggregate Demand In the long run, the output Y of an In the long run, the output Y of an

economy is determined with the economy is determined with the combination of labor, capital and combination of labor, capital and technology fully employed.technology fully employed.

In the short run, however, output is In the short run, however, output is determined by the level of aggregate determined by the level of aggregate demand.demand.

Aggregate demand is C+I+G+CA.Aggregate demand is C+I+G+CA.

Determinants of ConsumptionDeterminants of Consumption Consumption is a function of disposable Consumption is a function of disposable

income.income.YYdd = Y - T = Y - TC = YC = Ydd - S - SMPC = MPC = C/C/YYdd < 1. < 1.C = C (YC = C (Ydd))

Determinants of CADeterminants of CACA = EX - IMCA = EX - IMCA = CA(q,YCA = CA(q,Ydd))qq$/¥$/¥ = ($/¥)(P = ($/¥)(P¥¥/P/P$$))

qq$/¥$/¥ = E(P = E(P**/P)/P) If P* is the cost of a typical basket in If P* is the cost of a typical basket in

Japan and P is the cost of a typical Japan and P is the cost of a typical basket in USA.basket in USA.

Real exchange rate is the US basket Real exchange rate is the US basket per Japanese basket.per Japanese basket.

Real Exchange Rate to EXReal Exchange Rate to EX When real exchange rate qWhen real exchange rate q$/¥$/¥ = ($/¥)(P = ($/¥)(P¥¥/P/P$$) )

rises, foreign products become more rises, foreign products become more expensive relative to domestic products.expensive relative to domestic products.

Each unit of domestic basket purchases fewer Each unit of domestic basket purchases fewer units of foreign basket.units of foreign basket.

US basket per Japanese basket has US basket per Japanese basket has increased.increased.

Japanese will be more willing to buy US Japanese will be more willing to buy US products because the opportunity cost is lower products because the opportunity cost is lower now: EX goes up.now: EX goes up.

Real Exchange Rate to IMReal Exchange Rate to IM When real exchange rate qWhen real exchange rate q$/¥$/¥ = ($/¥)(P = ($/¥)(P¥¥/P/P$$) rises, ) rises,

domestic consumers will purchase fewer units of domestic consumers will purchase fewer units of the more expensive foreign products.the more expensive foreign products.

But imports in the aggregate demand stipulation But imports in the aggregate demand stipulation (C+I+G+EX-IM) is in terms of domestic real (C+I+G+EX-IM) is in terms of domestic real income, or domestic output units.income, or domestic output units.

Since more domestic output units may have to Since more domestic output units may have to be sacrificed for fewer foreign products, IM may be sacrificed for fewer foreign products, IM may increase or decrease as a result of q increase.increase or decrease as a result of q increase.

Real Exchange Rate and CAReal Exchange Rate and CAAs q increases, EX goes up.As q increases, EX goes up.As q increases, IM may go down or up.As q increases, IM may go down or up.Assuming that the volume effect on IM Assuming that the volume effect on IM

dominates the value effect, we can dominates the value effect, we can conclude that q increase will result in conclude that q increase will result in CA increase.CA increase.

A real appreciation of the yen will A real appreciation of the yen will increase US current account.increase US current account.

Disposable Income and CADisposable Income and CAAn increase in disposable income will An increase in disposable income will

increase consumption expenditures.increase consumption expenditures.Some of the consumption expenditures Some of the consumption expenditures

are on imports.are on imports.An increase in disposable income, An increase in disposable income,

therefore, will worsen the current therefore, will worsen the current account.account.

Variables of Aggregate Variables of Aggregate DemandDemand

1.1. Aggregate demand isAggregate demand isAD = C + I + G + CAAD = C + I + G + CA

1.1. C is dependent on disposable incomeC is dependent on disposable incomeC = C(Y-T)C = C(Y-T)

1.1. CA is dependent on real exchange rate and CA is dependent on real exchange rate and disposable incomedisposable income

CA = CA(qCA = CA(q$/¥$/¥ , Y-T) , Y-T)

1.1. Assuming I and G are given (exogenous), Assuming I and G are given (exogenous), aggregate demand will be determined by aggregate demand will be determined by q,Y-T, I, and G.q,Y-T, I, and G.

A CaveatA Caveat The full model should include determinants The full model should include determinants

of I (real interest rate) and S (real interest of I (real interest rate) and S (real interest rate and disposable income).rate and disposable income).

Of course, the impact of monetary sector on Of course, the impact of monetary sector on interest rates and exchange rates will need interest rates and exchange rates will need to be developed, too. That will come later.to be developed, too. That will come later.

Now we analyze the impact of the Now we analyze the impact of the stipulated variables on aggregate demand.stipulated variables on aggregate demand.

Real Exchange RateReal Exchange RateA rise in real exchange rate, qA rise in real exchange rate, q$/¥$/¥ = ($/¥) = ($/¥)

(P(P¥¥/P/P$$), makes domestic goods cheaper ), makes domestic goods cheaper

relative to Japanese goods.relative to Japanese goods.US exports increase and US imports US exports increase and US imports

(may) decrease.(may) decrease.CA rises, raising the aggregate CA rises, raising the aggregate

demand.demand.

Real IncomeReal Income If taxes are constant, an increase in real If taxes are constant, an increase in real

income (Y) will raise consumption and worsen income (Y) will raise consumption and worsen CA.CA.

Taxes usually respond to Y, so they need not Taxes usually respond to Y, so they need not be constant, but let’s assume they are.be constant, but let’s assume they are.

Typically, because of nontraded goods, a Typically, because of nontraded goods, a higher portion of the consumption increase higher portion of the consumption increase will go to domestic output rather than imports.will go to domestic output rather than imports.

The domestic consumption effect of income The domestic consumption effect of income increase will exceed the import effect and Y increase will exceed the import effect and Y increase will raise AD.increase will raise AD.

Real Income and Aggregate Real Income and Aggregate DemandDemand

A unit increase in real income will not A unit increase in real income will not increase consumption of domestic output increase consumption of domestic output by the same unit becauseby the same unit becausesome of the increase will go to imports.some of the increase will go to imports.Some of the increase will go to savings.Some of the increase will go to savings. If taxes respond to income, some of the If taxes respond to income, some of the

increase will go to taxes.increase will go to taxes. Aggregate demand as a function of real Aggregate demand as a function of real

income Y will have a slope less than income Y will have a slope less than one.one.

Equilibrium in the Output Equilibrium in the Output MarketMarket

Aggregate supply is the output produced Aggregate supply is the output produced (Y).(Y).

Equilibrium requires AD = AS.Equilibrium requires AD = AS. If we draw AD as a function of Y, then If we draw AD as a function of Y, then

equilibrium will only take place when Y = equilibrium will only take place when Y = AD, or along the 45 degree line.AD, or along the 45 degree line.

This analysis holds in the short run, that This analysis holds in the short run, that is output adjusts to bring equilibrium is output adjusts to bring equilibrium because we kept prices constant in the because we kept prices constant in the short run.short run.

Equilibrium in the Short RunEquilibrium in the Short Run

AD

Y

ADAD=Y

Y*Y1

At Y1, AD>Y. Firms respond to excess demand by increasing output, bringing the system toward Y*.

Y2

At Y2, Y>AD. Firms respond to excess supply by reducing production, bringing the system toward Y*.

Real Exchange RateReal Exchange RateA rise in the real exchange rate, qA rise in the real exchange rate, q$/¥$/¥ = =

($/¥)(P($/¥)(P¥¥/P/P$$), can occur either by nominal ), can occur either by nominal

appreciation of yen or rise in Japanese appreciation of yen or rise in Japanese price level or drop in US price level.price level or drop in US price level.

All of these will make US products All of these will make US products cheaper and will give a boost to CA.cheaper and will give a boost to CA.

Higher CA will translate into higher AD.Higher CA will translate into higher AD.

Equilibrium with q ChangeEquilibrium with q Change

AD

Y

ADAD=Y

Y1 Y2

A rise in q$/¥ , real depreciation of USD, will improve CA and increase AD.

AD’

Equilibrium will take place at the higher Y2.

Nominal Exchange Rates and Nominal Exchange Rates and Output EquilibriumOutput Equilibrium

In the short run both Japanese and US In the short run both Japanese and US price levels will remain constant.price levels will remain constant.

A nominal appreciation of the yen will A nominal appreciation of the yen will translate as a real appreciation of the yen.translate as a real appreciation of the yen.

The relationship between the nominal The relationship between the nominal exchange rate and the short run exchange rate and the short run equilibrium of the output will comprise the equilibrium of the output will comprise the DD curve.DD curve.

Nominal Exchange Rates and Nominal Exchange Rates and Output EquilibriumOutput Equilibrium

$/¥

AD

Y

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.

DD

Shifts of DD ScheduleShifts of DD ScheduleAny change in variables that will force Any change in variables that will force

the AD curve to shift will also shift the the AD curve to shift will also shift the DD curve in the same direction.DD curve in the same direction.Exception is a change in the nominal Exception is a change in the nominal

exchange rate; that change will be a exchange rate; that change will be a movement along the DD curve.movement along the DD curve.

All other forces that will change C, I, G, All other forces that will change C, I, G, CA will shift the DD curve.CA will shift the DD curve.

Shifts in DD ScheduleShifts in DD Schedule

$/¥

AD

Y

Y

DD

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.

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.

In all cases, $/¥ is kept constant.

Asset Market Equilibrium in the Asset Market Equilibrium in the Short RunShort Run

We will trace the required nominal exchange We will trace the required nominal exchange rate and real income to keep that will satisfy rate and real income to keep that will satisfy interest parity and monetary sector interest parity and monetary sector equilibrium. equilibrium.

Interest parityInterest parity

R = R* + (ER = R* + (Eee - E)/E - E)/EMonetary equilibriumMonetary equilibrium

MMss/P = L(R,Y)/P = L(R,Y)

Asset Market EquilibriumAsset Market Equilibrium

M/P

R

R

R

$/¥

E1

E2

Y up => real money demand up => R up => E down (USD appreciates)

R

Y1 Y2

AA

AA shows the assetmarket equilibrium.

MMss Decrease or P Increase Decrease or P Increase

M/P

R

R

R

$/¥

E1

E2

R

Y1

AA

Money supply decreaseor P increase raises R. At the same output level, $ appreciates and AA shifts left.

A Rise in EA Rise in Eee or R* or R*

M/P

R

R

R

$/¥

E1

E2

R

Y1

AA

An increase in the expected dollar returnsfrom yen deposits raises the exchange rate (yen appreciates).AA shifts right.

Equilibrium in Output and Equilibrium in Output and Asset MarketsAsset Markets$/¥

Y

AA

DDUnless 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

Point 1 implies $ returns on yen deposits have to behigher. If they are not, there will be flight from yen into $: E will fall.

2

At 2 asset market is in equilibrium but output market isn’t. AD>AS.Firms increase productionto meet excess demand.

Temporary MTemporary Ms s IncreaseIncrease

M/P

R

R

R

$/¥

E1

E2

R

Y1

AA

Ms up => R down => $ depreciates => CA improves => Y increases => real money demand rises => R increases => E falls ($ appreciates).

Temporary means the public expects the reversal of the policy in the future.

Temporary G Increase or T Temporary G Increase or T DecreaseDecrease

$/¥

AD

Y

Y

DD

AA

A one time increase in G raises Y. AD and DDboth shift to the blue lines. Even though the output market is in equilibrium, the higher income has raised the R and made $ more attractive.

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 Full Employment Policies for a Fall in Demand for Domestic Fall in Demand for Domestic

ProductsProductsE

AA

DD

Y1

E1

Fiscal expansion

Monetary expansion

Full Employment Policies for a Full Employment Policies for a Rise in Money DemandRise in Money Demand

E

AA

DD

Y1

E1Fiscal expansion

Monetary expansion

Permanent ShiftsPermanent Shifts A permanent change in fiscal and A permanent change in fiscal and

monetary policy affects the long run monetary policy affects the long run exchange rate.exchange rate.

Because permanent changes affect Because permanent changes affect expectations, they affect the current expectations, they affect the current exchange rates, as well.exchange rates, as well.

In the following examples, we will assume In the following examples, we will assume that the economy starts at full that the economy starts at full employment with expected exchange rate employment with expected exchange rate equal to current exchange rate, or R=R*.equal to current exchange rate, or R=R*.

Permanent MPermanent Ms s IncreaseIncrease

M/P

R

R

R

$/¥

E1

E2

R

Y1

AA

Ms up => R down => $ depreciates => CA improves => Y increases => real money demand rises => R increases => E falls ($ appreciates).

DD

The expected E rise ($ depreciation) makes the return curve shift and depreciate the $ even more.

Permanent MPermanent Ms s IncreaseIncreaseThe economy started at full employment The economy started at full employment

at Y1.at Y1.Higher money supply moved the Higher money supply moved the

economy to above Y1.economy to above Y1.As the price level adjusts to the higher As the price level adjusts to the higher

money supply two things happen:money supply two things happen:The real money supply falls shifting AA to The real money supply falls shifting AA to

the left.the left.Real appreciation of $ lowers CA and DD.Real appreciation of $ lowers CA and DD.

Permanent MPermanent Ms s IncreaseIncrease

M/P

R

R

R

$/¥

E1

E2

R

Y1

AA

DD

E3

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.

Permanent Fiscal ExpansionPermanent Fiscal Expansion

$/¥

AD

DD

AA

R YY1

P and M are constant; R doesn’t change. Gov. purchases increase the demand for US output and appreciate $ in the long run. G = -CA.

XX CurveXX CurveE

Y

DD

AA

XX

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 savingsto eliminate any excess supply. This means CA turns positive along DD.To the left of the intersection, CA turnsnegative along DD.

Monetary expansion, therefore, movesCA toward surplus.

Fiscal expansion moves CA toward deficit.