Slide 16-1Copyright © 2003 Pearson Education, Inc. Determinants of Aggregate Demand in an Open Economy Aggregate demand: The amount of a country’s goods

Slide 16-1

Copyright © 2003 Pearson Education, Inc.

Determinants of Aggregate Demand in an Open Economy

Aggregate demand: The amount of a country’s goods and services demanded by households and firms throughout the world.

D = C + I + G + CA• Consumption demand C = C(Yd)

– The increase in consumption demand is less than the increase in the disposable income because part of the income increase is saved.

• Investment demand I• Government demand G• Current account CA = EX – IM = CA(EP*/P,Yd)

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Real Exchange Rate q = EP*/P• Increase in q real depreciation increase in EX

– Each unit of domestic output purchases fewer units of foreign output foreigners get a better deal on our output foreigners buy more of our exports volume of EX up

• Increase in q can raise or lower IM and has an ambiguous effect on CA.

Volume effect: we buy fewer imports when q increases

Value effect: we pay more in real terms (in units of domestic product) for the imports we do buy when q increases

We assume that the volume effect of a real exchange rate change outweighs the value effect: q up CA “improves”.


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Factors Determining the Current Account

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Aggregate Demand as a Function of Output

Output (real income), Y

Aggregatedemand, D

Aggregate demand function,D(EP*/P, Y – T, I, G)

45°

The Equation of Aggregate Demand

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Output, Y

Aggregatedemand, D

45°

Aggregate demand = aggregate output, D = Y

Aggregate demand

2

Y2

D11

Y1

3

Y3

Output market equilibrium in the short-run: The Keynesian Cross. Real output, Y, equals aggregate demand for domestic output:

Y = D(EP*/P, Y – T, I, G)

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Output, the Exchange Rate, and Output Market Equilibrium

• With P and P* fixed, depreciation makes foreign goods and services more expensive relative to domestic goods and services.– q up (real depreciation) upward shift in

aggregate demand (D) expansion of output (Y).– q down downward shift in D Y down

Output Market Equilibrium in the Short Run: The DD Schedule

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Output Effect of a Currency Depreciation with Fixed Output Prices

Output, Y

Aggregatedemand, D

45°

D = Y

1

Y1

Aggregate demand (E2)


Y2

2Currencydepreciates

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Copyright © 2003 Pearson Education, Inc. Y2

DD

The DD Schedule: combinations of output and the exchange rate where output market is in short-run equilibrium (Y = D). DD slopes upward -- a rise in the exchange rate (depreciation) Y increases.

Output, Y

Aggregate demand, D D = Y

Y1



Y2

Output, Y

Exchange rate, E

Y1

1E1

E2

2

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Factors that Shift the DD Schedule. Increases in• Government purchases expansion DD shifts out

• Taxes contraction DD shifts in

• Investment expansion DD shifts out

• Domestic price levels contraction in CA DD shifts in

• Foreign price levels expansion in CA DD shifts out

• Domestic consumption expansion DD shifts out

• Demand shift between foreign and domestic goods

A disturbance that raises (lowers) aggregate demand for domestic output shifts the DD schedule to the right (left).


Slide 16-10

Copyright © 2003 Pearson Education, Inc. Y2

Output Market Equilibrium in the Short Run: The DD ScheduleGovernment Demand and the Position of the DD Schedule

D = Y

Y1

D(E0P*/P, Y – T, I, G2)

D(E0P*/P, Y – T, I, G1)

Y2

Output, Y

Exchange rate, E

Y1

Aggregate demand curves

2

Government spending rises

Output, Y

Aggregate demand, D

DD1

E01

DD2

Slide 16-11


Foreign exchange market equilibrium (interest rate parity):

R = R* + (Ee – E)/Ewhere: Ee is the expected future exchange rate

R is the interest rate on domestic currency deposits

R* is the interest rate on foreign currency deposits

Money Market equilibrium

Ms/P = L(R, Y)

AA Schedule: combinations of exchange rate and output that are consistent with asset market equilibrium (the domestic money market and the foreign exchange market).

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Asset Market Equilibrium in the Short Run: The AA Schedule

Output and the Exchange Rate in Asset Market Equilibrium: Y up Ld up R up E down (currency appreciates)

Domestic-currency return on foreign-currency deposits

Foreignexchangemarket

Moneymarket

E2 2'

R2

E1 1'

R1

Real moneysupply

MS

P 1

L(R, Y2)

L(R, Y1)

Real domestic money holdings

Domestic interestrate, R

Exchange Rate, E

0

2

Output rises

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The AA Schedule: Y up E down (currency appreciation)

Output, Y

Exchange Rate, E


AA

Y1

E11

Y2

E22

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Factors that Shift the AA Schedule For given Y

Domestic money supply: Ms up R down E up

Domestic price level: P up Ms/P down R up E down

Expected future exchange rate: Ee up E up

Foreign interest rate: R* up E up (depreciation)

Real money demand: Ld up R up E down (appreciation)


Slide 16-15


Short-Run Equilibrium: The Intersection of DD and AA

Output, Y

Exchange Rate, E

AA

Y1

E11

Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together

DD

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How the Economy Reaches Its Short-Run Equilibrium: asset markets clear instantly always on AA curve

$ cheap at 2 Expected $ appreciation rush to US assets $ appreciation NOW

AA

Y1

E11

Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together

DD

3E3

2E2

Output, Y

Exchange Rate, E

Slide 16-17


Temporary Changes in Monetary and Fiscal Policy

Two types of government policy:• Monetary policy: works through changes in money supply.

• Fiscal policy: works through changes in government spending (G) or taxes (T).

– Temporary policy shifts are those that the public expects to be reversed in the near future and do not affect the long-run expected exchange rate.

– Also, assume policy shifts do not influence the foreign interest rate and the foreign price level.

Slide 16-18


DD

Temporary Increase in the Money Supply: R down E up (depreciation) at each value of Y AA shifts up

Output, Y

Exchange Rate, E

AA2

Y2

E22

AA1

1E1

Y1

Temporary Change in Monetary Policy

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DD1

Temporary Fiscal Expansion: G up Y increases at each value of E DD shifts outward

Output, Y

Exchange Rate, E

AA

DD2

Y1

E11

2

Y2

E2

Temporary Change in Fiscal Policy

Slide 16-20


Maintaining Full Employment After a Temporary Fall in World Demand for Domestic Products: Prop up demand with fiscal or monetary stimulus (M up AA shifts up; G up DD shifts out)

Output, Y

Exchange Rate, E

DD1

AA2

AA1

YfY2

E22

DD2

1E1

3E3


Slide 16-21


DD1

Policies to Maintain Full Employment After Money-Demand Up (Money “shortage” recession). So Increase G or Ms

Output, Y

Exchange Rate, E

DD2

AA1

AA2

YfY2

E22

3E3

1E1


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Problems of Policy Formulation

• Inflation bias– High inflation with no average gain in output that

results from governments’ policies to prevent recession

• Identifying the sources of economic changes

• Identifying the durations of economic changes

• The impact of fiscal policy on the government budget

• Time lags in implementing policies

• Policy impacts on current account balance

Slide 16-23


Permanent Shifts in Monetary and Fiscal Policy

A permanent policy shift affects not only the current value of the government’s policy instrument but also the long-run exchange rate.• This affects expectations about future exchange rates.

A Permanent Increase in the Money Supplyexpected future exchange rate (Ee)rises proportionally

upward shift in AA schedule is greater than that caused by an equal, but transitory, increase need expected appreciation in the future to offset lower

interest rate, ROVERSHOOTING

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DD1

Short-Run Effects of a Permanent Increase in the Money Supply (E3 is newly expected long-run exchange rate)

Output, Y

Exchange Rate, E

AA2

Y2

E22

AA1

1E1

Yf

3


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DD2

Long-Run Adjustment to a Permanent Increase in Money Supply (As P rises, CA worsens (DD in) and R rises (AA down)

Output, Y

Exchange Rate, E

DD1

AA2

AA3

Yf

3E3

AA1

Y2

E2

2

E11


Slide 16-26


DD1

Expected Appreciation Shifts AA Down ImmediatelyNo Change in Output, Even in Short-Run

Complete Crowding Out

Output, Y

Exchange Rate, E

DD2

AA1

AA2

Yf

2E2

1E1

Permanent Fiscal Expansion

3

Slide 16-27


Macroeconomic Policies and the Current Account

XX schedule shows combinations of the exchange rate and output at which the CA balance stays at some desired level.• XX slopes upward: Y up Im up CA worsens unless

currency depreciates.– E must increase to keep CA where it was when Y up.

• XX is flatter than DD: – When currency depreciates (E up), CA improves along DD –

that’s why Y increases when currency depreciates.– To keep CA from changing, E need only increase enough to

offset increased imports attributable to output expansion.

Slide 16-28


Output, Y

Exchange Rate, E

AA

Yf

E11

DD

XX

4

3

2

Monetary Expansion AA shifts up Depreciation CA “improves” (Point 2)Fiscal Expansion DD shifts out Appreciation CA “worsens” (Point 3 for temporary fiscal expansion; Point 4 for permanent fiscal expansion).

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The J-Curve: if imports and exports adjust gradually to real exchange rate changes, the CA may follow a J-curve pattern after a real currency depreciation, first worsening and then improving.

– Currency depreciation may have a contractionary initial effect on output

– exchange rate overshooting will be amplified.

• The J-Curve describes the time lag with which a real currency depreciation improves the CA.

Gradual Trade Flow Adjustment and Current Account Dynamics

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2

The J-Curve

Time

Current account (in domestic output units)

1 3

Long-runeffect of real depreciationon the currentaccount

Real depreciation takes place and J-curve begins

End of J-curve


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Exchange Rate Pass-Through and Inflation• The CA in the DD-AA model has assumed that

nominal exchange rate changes cause proportional changes in the real exchange rates in the short run.

• Degree of Pass-through– It is the percentage by which import prices rise when

the home currency depreciates by 1%.– In the DD-AA model, the degree of pass-through is 1.

– Exchange rate pass-through can be incomplete because of international market segmentation.

– Currency movements have less-than-proportional effects on the relative prices determining trade volumes.


Slide 16-32


Summary

The aggregate demand for an open economy’s output consists of four components: consumption demand, investment demand, government demand, and the current account.

Output is determined in the short run by the equality of aggregate demand and aggregate supply.

The economy’s short-run equilibrium occurs at the exchange rate and output level.

Slide 16-33


Summary

A temporary increase in the money supply causes a depreciation of the currency and a rise in output.

Permanent shifts in the money supply cause sharper exchange rate movements and therefore have stronger short-run effects on output than transitory shifts.

If exports and imports adjust gradually to real exchange rate changes, the current account may follow a J-curve pattern after a real currency depreciation, first worsening and then improving.

Slide 16-34


Figure 16AI-1: Short-Run Equilibrium in the IS-LM Model

Output, Y

Interest rate, R

Y1

R11

Appendix I: The IS-LM Model and the DD-AA Model

LM

IS

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R2

Figure 16AI-2: Effects of Permanent and Temporary Increases in the Money Supply in the IS-LM Model


R3

LM2

Output, Y

Interest rate, RLM1

Y3

3

Y2

2

Y1

1R1

3´

E3

1´

E1E2

2´

Exchange rate, E ( increasing)

Expected domestic-currency return on foreign-currency deposits

IS1

IS2

Slide 16-36


R2

Figure 16AI-3: Effects of Permanent and Temporary Fiscal Expansions in the IS-LM Model


R1

Output, Y

Interest rate, R LM

Yf

1

Y2

22´

E2

Exchange rate, E ( increasing)

Expected domestic-currency return on foreign-currency deposits

E1

1´

E3

3´

IS1

IS2

Slide 16-37


Appendix II: Intertemporal Trade and Consumption Demand

Present consumption

Futureconsumption

D1P = Q1

P

1

Figure 16AII-1: Change in Output and Saving

Indifferencecurves

Intertemporalbudget constraintsIntertemporalbudget constraints

2

D2P

2´

Q2P

D1F = Q1

F

D2F

Slide 16-38


Appendix III: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities

Table 16AIII-1: Estimated Price Elasticities for International Trade in Manufactured Goods

Documents

Slide 16-1Copyright © 2003 Pearson Education, Inc. Determinants of Aggregate Demand in an Open Economy Aggregate demand: The amount of a country’s goods