Prices and Output in the Open Economy:

Aggregate Supply and Demand

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 27Chapter 27

27-2

Learning Objectives Explain the fundamental links between

international transactions and aggregate supply and aggregate demand.

Demonstrate how economic shocks and policies affect prices and output.

Differentiate between macroeconomic adjustment under fixed exchange rates and under flexible exchange rates.

Distinguish between short-run and long-run effects of macro policies on output and prices.

27-3

Aggregate Demand in the Closed Economy

In the closed economy, macroeconomic equilibrium occurs where IS and LM curves intersect.

When prices change, IS curve is not affected.

When prices change, real money supply changes, shifting the LM curve.

We can trace out the aggregate demand (AD) curve by seeing how Y changes as P changes.

Derivation of Aggregate Demand Curve: Closed Economy

i

Y Y

P

IS

LM0(P0)

Y0

i0

P0

Y0

LM1(P1)

Y1

i1

P1

LM2(P2)

Y2

i2

Y1Y2

P2

AD

27-4

27-5

Aggregate Demand in the Closed Economy

The more elastic IS or LM are, the more elastic AD will be.

If IS shifts right (left), AD shifts right (left).

An increase in the tax rate makes IS and AD steeper.

When LM shifts right (left), AD shifts right (left).

27-6

Aggregate Supply in the Closed Economy

AS is determined by: • level of technology,• quantity of resources available,• efficiency with which resources are used, and• level of employment of resources.

In the short run, the first 3 are assumed fixed.

Employers hire workers up to the point where wage equals the marginal revenue product: W=P•MPPN.

Aggregate Production and the Demand for Labor

Y

N N

W, MPPN

IS

N0

Y0

W0

N0N1

Y1

N2

Y2

Y1Y2

MRPN0

MRPN1MRPN2

27-7

27-8

Aggregate Supply in the Closed Economy

Suppose W is fixed – this mean firms can hire as much labor as they wish at the going wage (labor supply is perfectly elastic).

If P increases, MRPN shifts rightwards. This leads to a higher level of

employment and thus output. Therefore P and Y are directly related.

27-9

The Aggregate Supply Curve With a Fixed Wage

P

YY2 Y0

P0

P2

Y1

P1

AS

27-10

Aggregate Supply in the Closed Economy

However, labor supply is probably not perfectly elastic – to induce a greater quantity of labor supplied, wages must rise.

The resulting AS curve will be steeper.

Variable Wages and the Aggregate Supply Curve

W, MRP

Y

P

N0

W0 P0

Y0N1

W1

N2

W2

Y1Y2

MRP1MRP0MRP2

P2

P1

ASNS

27-11

27-12

Aggregate Supply in the Closed Economy

In fact, the quantity of labor supplied depends on the real wage.

Once workers realize that P has risen they will demand a higher wage.

This means that an increase in P may temporarily “fool” workers into supplying a higher quantity labor (and thus produce more output), but labor supply will shift leftwards eventually; Y returns to natural level of income.

27-13

Labor Market Adjustment to Higher Prices

P

Y

MRPN

W0

W2

MRP'N

W1

SN

S'N

N0 N1

27-14

Equilibrium in the Closed Economy

Putting aggregate supply and aggregate demand together allows us to see equilibrium output and price level.

If for whatever reason AD increases, there will be a temporary increase in output and prices.

Once workers realize P has increased, they will decrease labor supply.

This will shift AS leftwards, leaving us with the original Y but a higher price level.

27-15

Equilibrium in the Closed Economy

P

YY0

P0

P2

Y1

P1

ASSR0

AD0

AD1

ASSR1

ASLR

27-16

Equilibrium in the Closed Economy

The short run AS curve is upward-sloping. The long run AS curve is a vertical line.

27-17

Aggregate Demand in the Open Economy Under Fixed

Rates When the economy is open, we must also

consider the BP curve when deriving AD. If P increases:

• LM shifts leftwards.• BP shifts leftwards.• IS shifts leftwards.

Ultimately, a new equilibrium will occur at a lower level of Y.

Aggregate Demand in the Open Economy Under Fixed Rates

i

Y Y

P

ISP0

Y0

i0 P0

Y0Y1

i1

Y1

P1

AD

LMP0

BPP0

LMP1

BPP1

ISP1

27-18

27-19

Aggregate Demand in the Open Economy Under

Flexible Rates If P increases:

• LM shifts leftwards.• BP shifts leftwards.• IS shifts leftwards.

An incipient surplus or deficit may ensue, causing exchange rate adjustment and further shifts of BP and IS.

Ultimately, a new equilibrium will occur at a lower level of Y.

27-20

Effect of Exogenous Shocks on AD Curve Under Fixed and

Flexible RatesFixed Flexible

Δ in partner-country variable that increases home-country exports

AD shifts right

No effect on AD

Δ in partner-country variable that alters short-term capital flows in partner-country’s favor

AD shifts left

AD shifts right

Δ in home-country variable that reduces home-country exports

AD shifts left

No effect on AD

Δ in home-country variable that stimulates short-term capital inflows

AD shifts right

AD shifts left

Expansionary monetary policy No effect on AD

AD shifts right

Expansionary fiscal policy AD shifts right

Little effect on AD

27-21

Monetary Policy in AS/AD Framework: Flexible Rates

Since monetary policy in the presence of fixed rates has limited effect on AD, we focus on a flexible rate regime.

Expansionary monetary policy shifts AD rightwards, with higher Y and P.

Eventually, workers realize P is higher and decrease labor supply.

This shifts AS leftwards. The economy return to the original level

of Y, but with higher P.

27-22

Monetary Policy in AS/AD Framework: Flexible Rates

P

YY0

P0

P2

Y1

P1

ASSR0

AD0

AD1

ASSR1

ASLR

27-23

Fiscal Policy in AS/AD Framework: Fixed Rates

Since fiscal policy in the presence of flexible rates has limited effect on AD (esp. if capital is relatively mobile), we focus on a fixed rate regime.

Expansionary fiscal policy shifts AD rightwards, with higher Y and P.

Eventually, workers realize P is higher and decrease labor supply.

This shifts AS leftwards. The economy return to the original level

of Y, but with higher P.

27-24

Fiscal Policy in AS/AD Framework: Fixed Rates

P

YY0

P0

P2

Y1

P1

ASSR0

AD0

AD1

ASSR1

ASLR

27-25

Economic Policy and Supply Considerations

Some policies can also affect AS. For example, suppose a tax cut not only

expands AD, but also causes AS to shift to the right, as supply-side economists predict?

The tax cut will end up increasing Y, but the ultimate effect on P is ambiguous.

27-26

Economic Policy and Shifts in the Long-Run AS Curve

P

YY0

P0

Y1

ASSR0

AD0

AD1

ASSR1

ASLR AS'LR

?

?

27-27

External Shocks: Increase in Price of Imported Input

What if a critical imported input (e.g., crude oil) increases in price?

In a flexible exchange rate system, this causes• a depreciation of the home currency,• an expansion of AD, and• a leftward shift of short- and long-run AS.

The result may be stagflation: simultaneous decreases in income coupled with rising prices.

27-28

Effect of a Price Shock of an Imported Input

P

YY0

P0

Y1

P1

ASSR0

AD0

AD1

ASSR1

ASLR0

ASLR1

Y2

27-29

External Shocks: Foreign Financial Shock

What if a foreign financial shock triggers an inflow of short-term capital?

In a flexible exchange rate system, this causes• an appreciation of the home currency,• an contraction of AD, and• lower income and prices.

The economy could return to original Y by expansionary monetary or fiscal policy, or wait for the LR adjustment.

27-30

External Shocks: Foreign Financial Shock

P

YY0

P0

Y1

P1

ASSR0

AD0

AD1

ASLR0

27-31

External Shocks: Technological Change

What if technological change occurs? SR AS shifts rightwards, temporarily giving us a

new equilibrium with higher income and lower prices (at P1 and Y1).

But LR AS also shifts rightwards, perhaps to the right of Y1.

Now the economy is below its new natural level, Y2.

The economy will adjust by a further rightward shift of SR AS, or expansionary monetary or fiscal policy could be employed.

27-32

External Shocks: Technological Change

P

YY0

P0

Y1

P1

ASSR0-W0

AD0

AD1

ASLR0

ASSR1-W0ASLR1

Y2

P2

ASSR1-W1