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Chapter 11.2 11.4 Heiko Lampe
Aggregate demand and output
11.1 Overview
This chapter will take the Keynesian assumption that prices are constant as a starting
point. In this chapter the exchange rates will enter the game and we will observe, what
the Keynesian model is. The broad overview can be deducted from the figure below.
11.2 Short-run fluctuations output, employment and unemployment
In the short run capital is fixed. Firms can alter their production by labor usage, extra
hours and so on. Thus they deviate from their original output trend, which is described
as an output gap.
The relation between output growth and unemployment is known as Okuns Law. A
certain amount of output is linked to a certain amount of unemployment, holding the
number of workers fixed and the hours worked per worker. This can be represented in
a graph like:
U-Ubar = -g(Y-Ybar)
Ubar U= real unemployment rate
Ubar= medium run / trend /Blanchard
g = constant factor
Y = real GDP growth
Ybar = growth trend GDP
Ybaroutput
An increase of output in this model is possible when decreasing unemployment.
Unemployment
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11.3 The IS-LM Model in the open economy
Exogenous variables are given and do not have to be explained. Endogenous
variables have to be explained in the model. Some variables are exogenous or
endogenous depending on the exchange rate regime. When the nominal exchange
rate is fixed, the real exchange rate is exogenous if we assume the foreign anddomestic prices to be constant.
As discussed earlier, the total output is dependent of consumption, Investments and
government spending. Now we add to all this PCA, the primary current account. Thus
the exports and import enter the scene. PCA = X-Z = ExportsImports.
Import function: Z = Z(A, ) with A= domestic Absorption(C+I+G) and = real
exchange rate + +
Export function: X = X(A*, ) with A*= total foreign Absorption
+ -
If the domestic Absorption increases, the imports will increase, an increase in the
exchange rate will make it cheaper to buy outside and will increase imports as well.
Of course the latter effect is reversed for the export function. If the Absorption in the
foreign country increases however, the exports will increase as well.
For PCA = X Z follows: PCA = PCA (A, A*, )
- + -
The current account function can now be written as PCA = PCA (Y, Y*, )since the dependence on A is fundamentally a dependence on A - + -
Coming back to the 45 degree diagram with an open economy will give the same
picture as before. The DD-Equation is now a little longer and looks like:
DD = C (, Y T) + I(i, q) + G + PCA (Y, Y*, )
Here the q in the Investment function is Tobins q. The graph looks the same, but the
DD line is flatter to account for the fact, that the PCA declines as income increases,
because more is imported from abroad, reducing the net effect of an income increase.
The next graph will show how output adjusts to desired demand. If the DD line shifts
upward (due to an increase in government spending for example), the demand goes up
to point B, motivating the producers to increase production. The higher production
leads to higher income and thus new demand, resulting in the producers to increase
their production again. Thus we will end up in the new equilibrium point. What is
important is that the GDP or output will increase more than the initial increase in
government spending and there is a multiplier effect, the demand multiplier. This is
mathematically easily explained with the flatter DD line. However, the graph is on the
next page and it should not give any problems to follow the steps.
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The multiplier and the slope of the IS curve are interlinked. The larger the multiplier,
the flatter is the curve. This is due to the larger output increase resulting from a shiftof the DD curve. Graphically:
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If the DD becomes flatter due to a including of PCA (some effects are taken out of the
country via imports), the IS curve gets steeper. The shift has the same extent, but the
equilibrium output will be lower. Consequently, the IS gets steeper.
If marginal propensity to consume goes up, DD gets steeper. If marginal propensity to
import goes up, DD gets flatter. If the PCA goes up, the DD gets steeper as well
The multiplier is finite, because ofleakages. An increase in GDP is not fully
translated into new domestic demand via higher income. There are three leakages:
Taxes, savings and imports. The higher income may be saved, go to the government
or be used to import. Thus the multiplier is dependent of the marginal propensity to
save and import.
It is important to distinguish between shifts of and movements along the IS curve.
Every change of an exogenous variable shifts the curve. A change of an endogenous
variable causes a movement along the curve.
The small country assumption says that the domestic situation does not influence
the foreign. The foreign rate of return i* is exogenous. So if you can get money in the
domestic market and invest it in the foreign market at a better price, this is called
arbitrage, you will make the interest rate in the domestic market change and adjust.
Overall, with the expected exchange rate development the interest you can earn
domestically and in the foreign market are after changing your money back the same.This phenomenon is called interest parity. i=i* the domestic return is equal to the
foreign return. Since in this course the exchange rates are fixed that means that the
interest rates in both countries are the same and the small country adjusts to changes
in the big one (like Germany and The Netherlands years ago).
The LM curve is not directly affected by the interest parity condition. It just describe
the equilibrium in the domestic money market. Due to the small country assumption
however, the adjustment of the interest has to come over the money market. In
addition to that the money supply has to be regulated to hold the exchange rate fixed.
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Of course it is important to distinguish again between movements along the LM and
shifts of the LM. Here real money supply and the transaction costs are exogenous. In
the Figure on this page the exogenous change of nominal money supply shifts the
curve.
In this chapter we assume the wages and prices to be fixed. We can ignore the labor
market, because it will adjust passively. Supply adjusts on all markets to the demand.This is the key issue of the Keynesian approach to macroeconomic. In addition to that
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this chapter allows us to connect with the rest of the world by opening the economy.
This opening is to search in the IS curve. The LM curve stays unaffected. The
international financial market replaces the labor market and we have three markets
again to bring them into one general equilibrium.
The international financial market is just the fact that you should get the same returneverywhere. This is not dependent of GDP. The financial integration line captures
this:
i* financial integration line
GDP
i* is the foreign interest rate
Bringing this together with the usual IS-LM-Model gives us the Mundell-Fleming
model and looks like the graph below
IS LM
i* E financial integration line
GDP
Here we can observe the equilibrium of all three markets in point E.
The rest of this chapter will explain how GDP and interest rate respond on various
exogeneous disturbances. The approach is always the same: Find out which of the three curves will shift
What has to happen to make them go through one point again?
How does the economy move from one to the other equilibrium?
This has to be, because none of the markets can be in disequilibrium for a long time.
The financial integration line has to come to an equilibrium, because arbitrage does
not last long. The goods market will adjust with inventory and output movements.
The money market will clear very fast as well.
interestrate
interestrate
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11.4 output and interest rate determination under fixed exchange rates
An increase of the money supply will lead to a right shift of the LM-curve. Now there
are three possibilities: either the IS curve restores the equilibrium, or the financial
integration line, or the LM curve shifts back! Since the exchange rate is fixed, a
decrease of the interest rate would bring a lot of domestic investors out of the country.This would give pressure on the exchange rate, forcing the authorities to buy back the
own currency by using foreign assets. Finally that will decrease the money supply and
the LM curve will shift back again.An increase in the money supply implies a rightward shift of theLM. At point B (with a lower interest rate) capital outflowsforce the central bank to intervene and the money supply
contracts, until the economy returns to point A. Monetary policy
is ineffective.
This result leads us to the experience that the LM curve is endogenous and will adjust
always. So monetary policy is ineffective under fixed exchange rates. This problem
resulted in the invention ofcapital controls. In some countries it is not possible to
bring capital freely out of the country. So the domestic interest rate is a bit
independent of the world market, allowing for adjustments, which would be
impossible without the restrictions.
If any exogenous factor changes and the demand is increased, the results can be
observed in figure 11.14. The new IS-LM intersects comes along with a higher
interest rate and will thereby affect investments negatively which is called crowding
out. The LM will shift out, because of the capital inflow.
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