Скачать презентацию Topic 10 Output and the Exchange Rate in Скачать презентацию Topic 10 Output and the Exchange Rate in

e2fa24e6ab92852cfc937191b6631572.ppt

  • Количество слайдов: 67

Topic 10 Output and the Exchange Rate in the Short Run Slides prepared by Topic 10 Output and the Exchange Rate in the Short Run Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Preview • Determinants of aggregate demand in the short run • A short run Preview • Determinants of aggregate demand in the short run • A short run model of output markets • A short run model of asset markets • A short run model for both output markets and asset markets • Effects of temporary and permanent changes in monetary and fiscal policies • Adjustment of the current account over time Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 2

Introduction • Previously, we examined the linkages between exchange rates, interest rates, and price Introduction • Previously, we examined the linkages between exchange rates, interest rates, and price levels but always assumed that output levels were determined outside the model. • Here we complete our picture of the economy by including how output and the exchange rate are determined in the SR. ¨ Present a theory of how output adjusts to demand changes when prices are slow to adjust. ¨ It shows how macroeconomic policies can affect production, employment, and the current account. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3

Introduction (cont. ) • The LR exchange rate model (of the previous lecture) provides Introduction (cont. ) • The LR exchange rate model (of the previous lecture) provides the framework that asset market participants use to form their expectations about future exchange rates. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4

Determinants of Aggregate Demand • Aggregate demand is the amount of goods and services Determinants of Aggregate Demand • Aggregate demand is the amount of goods and services that individuals and institutions are willing to buy. It is the sum of: 1. 2. 3. 4. consumption expenditure (C) investment expenditure (I) government purchases (G) net expenditures by foreigners (EX-IM): the current account (CA) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5

Determinants of Aggregate Demand (cont. ) • Determinants of C include: ¨ Disposable income Determinants of Aggregate Demand (cont. ) • Determinants of C include: ¨ Disposable income (Yd): income from production (Y) minus taxes (T). ¨ More Yd means more C, but C typically increases less than the amount that Yd increases because part of Yd is saved. ¨ Real interest rates may influence the amount of saving and thereby C, but we assume that they are relatively unimportant here. ¨ Wealth may also influence C, but we assume that it is relatively unimportant here. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6

Determinants of Aggregate Demand (cont. ) • Determinants of the CA include: ¨ Real Determinants of Aggregate Demand (cont. ) • Determinants of the CA include: ¨ Real exchange rate: prices of foreign products relative to the prices of domestic products, both measured in domestic currency: EP*/P § As the prices of foreign products rise relative to those of domestic products, expenditure on domestic products rises, and expenditure on foreign products falls. ¨ Disposable income: more disposable income means more expenditure on foreign products (imports) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7

How Real Exchange Rate Changes Affect the Current Account • The CA measures the How Real Exchange Rate Changes Affect the Current Account • The CA measures the value of exports relative to the value of imports: CA ≈ EX – IM. ¨ When the real exchange rate EP*/P rises, the prices of foreign products rise relative to the prices of domestic products. 1. The volume of exports that are bought by foreigners rises. 2. The volume of imports that are bought by domestic residents falls. 3. The value of imports in terms of domestic products rises: the value/price of imports rises, since foreign products are more valuable/expensive. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8

How Real Exchange Rate Changes Affect the Current Account (cont. ) • If the How Real Exchange Rate Changes Affect the Current Account (cont. ) • If the volumes of imports and exports do not change much, the value effect may dominate the volume effect when the real exchange rate changes. ¨ E. g. , contract obligations to buy fixed amounts of products may cause the volume effect to be small. • However, evidence indicates that for most countries the volume effect dominates the value effect after one year or less. ¨ Import and export demands tend to be relatively elastic. • Let’s assume for now that a real depreciation leads to an increase in the CA: the volume effect dominates the value effect. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9

Determinants of Aggregate Demand • Determinants of the CA include: ¨ Real exchange rate: Determinants of Aggregate Demand • Determinants of the CA include: ¨ Real exchange rate: an increase in the real exchange rate (i. e. , ↑EP*/P) increases the CA. ¨ Disposable income: an increase in disposable income decreases the CA. • Note: an ↑Yd does not affect export demand because we are holding foreign income constant and not allowing Yd to affect it. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10

Determinants of Aggregate Demand (cont. ) • For simplicity, we assume that exogenous political Determinants of Aggregate Demand (cont. ) • For simplicity, we assume that exogenous political factors determine government purchases (G) and the level of taxes (T). • For simplicity, we assume that investment expenditure (I) is determined by exogenous business decisions. ¨ More complicated models show that I depends on the cost of borrowing to finance investment: the interest rate. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 11

Determinants of Aggregate Demand (cont. ) • Aggregate demand is therefore expressed as: D Determinants of Aggregate Demand (cont. ) • Aggregate demand is therefore expressed as: D = C(Y – T) + I + G + CA(EP*/P, Y – T) Consumption expenditure as a function of disposable income Investment expenditure and government purchases, both exogenous Current account as a function of the real exchange rate and disposable income. • Or more simply: D = D(EP*/P, Y – T, I, G) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. (equation 1) 12

Determinants of Aggregate Demand (cont. ) • Determinants of aggregate demand include: ¨ Real Determinants of Aggregate Demand (cont. ) • Determinants of aggregate demand include: ¨ Real exchange rate: an increase in the real exchange rate increases the CA, and therefore increases aggregate demand for domestic products. ¨ Disposable income: an increase in disposable income increases C, but decreases the CA by raising home spending on foreign imports. • Since C is usually greater than expenditure on foreign products (IM), an increase in domestic income will raise aggregate demand for home output. • As income increases for a given level of taxes, C increases by less than the increase in income (because of savings) and aggregate demand increases by less than the increase in C (because of IM). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13

Short Run Equilibrium for Aggregate Demand Output • Equilibrium is achieved when real domestic Short Run Equilibrium for Aggregate Demand Output • Equilibrium is achieved when real domestic output (Y) equals the aggregate demand for domestic output (D). Y = D(EP*/P, Y – T, I, G) Value of output and income from production Aggregate demand as a function of the real exchange rate, disposable income, investment expenditure and government purchases Equilibrium condition Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14

Fig. 1: The Determination of Output in the SR Why is Y 1 the Fig. 1: The Determination of Output in the SR Why is Y 1 the SR equilibrium level of output? If output were lower (Y 2) then spending > output → ↓firms’ inventories → ↑output. If output were higher (Y 3) then spending < output → ↑firms’ inventories → ↓output. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15

Short Run Equilibrium and the Exchange Rate: DD Schedule • How does the exchange Short Run Equilibrium and the Exchange Rate: DD Schedule • How does the exchange rate affect the SR equilibrium of aggregate demand output? • With fixed price levels at home and abroad, a rise in the nominal exchange rate makes foreign goods and services more expensive relative to domestic goods and services. • A rise in the nominal exchange rate (a domestic currency depreciation) increases aggregate demand for domestic products. • In equilibrium, production will increase to match the higher aggregate demand. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16

Fig. 2: Output Effect of a Currency Depreciation with Fixed Output Prices A currency Fig. 2: Output Effect of a Currency Depreciation with Fixed Output Prices A currency depreciation lowers the relative price of domestic goods and services. This improves the CA and causes the aggregate demand curve to shift upward. Domestic firms respond to the higher level of spending by raising their output levels from Y 1 to Y 2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 17

Fig. 3: Deriving the DD Schedule A depreciation of the domestic currency shifts the Fig. 3: Deriving the DD Schedule A depreciation of the domestic currency shifts the aggregate demand curve upward causing output to rise. Point 1 on the DD schedule gives the output level Y 1 at which aggregate demand equals aggregate supply when the exchange rate is E 1. A depreciation of the currency to E 2 leads to the higher output level Y 2 which is shown on point 2 of the DD schedule. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 18

Short Run Equilibrium and the Exchange Rate: DD Schedule (cont. ) DD schedule: • Short Run Equilibrium and the Exchange Rate: DD Schedule (cont. ) DD schedule: • shows combinations of output and the exchange rate at which the output market is in SR equilibrium (so that aggregate demand = aggregate output). • slopes upward because a rise in the exchange rate causes aggregate demand aggregate output to increase. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 19

Shifting the DD Curve • Changes in the exchange rate cause movements along the Shifting the DD Curve • Changes in the exchange rate cause movements along the DD curve. Other changes cause it to shift: 1. Changes in G: more government purchases cause higher aggregate demand output in equilibrium. Output increases for any given exchange rate: the DD curve shifts out. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 20

Fig. 4: Government Spending and the Position of the DD Schedule An increase in Fig. 4: Government Spending and the Position of the DD Schedule An increase in government purchases from G 1 to G 2 shifts the aggregate demand curve upward. Firms respond by increasing their output from Y 1 to Y 2. At a given exchange rate E 0, the higher level of spending and output leads to an outward shift of the DD curve. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 21

Shifting the DD Curve (cont. ) 2. Changes in T: lower taxes raise Yd Shifting the DD Curve (cont. ) 2. Changes in T: lower taxes raise Yd and thereby increase C, increasing aggregate demand output in equilibrium for any given exchange rate: the DD curve shifts out. 3. Changes in I: higher investment expenditure is represented by shifting the DD curve out. 4. Changes in P relative to P*: lower domestic prices relative to foreign prices are represented by shifting the DD curve out. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22

Shifting the DD Curve (cont. ) 5. Changes in C: willingness to consume more Shifting the DD Curve (cont. ) 5. Changes in C: willingness to consume more and save less is represented by shifting the DD curve out. 6. Changes in demand for domestic goods relative to foreign goods: willingness to consume more domestic goods relative to foreign goods is represented by shifting the DD curve out. • Any change that raises aggregate demand for domestic output shifts DD out; while any change that lowers aggregate demand for domestic output shifts DD in. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23

Short Run Equilibrium in Asset Markets • We consider two sets of asset markets: Short Run Equilibrium in Asset Markets • We consider two sets of asset markets: 1. Foreign exchange market ¨ interest parity represents equilibrium: R = R* + (Ee – E)/E 2. Money market ¨ Equilibrium occurs when the quantity of real money supplied matches the quantity of real money demanded: Ms/P = L(R, Y) ¨ A rise in income from production causes the real demand for money to increase. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 24

Fig. 5: Output and the Exchange Rate in Asset Market Equilibrium Points 1 and Fig. 5: Output and the Exchange Rate in Asset Market Equilibrium Points 1 and 1’ show the equilibrium interest rate (R 1) and the equilibrium exchange rate (E 1) associated with the output level Y 1. An increase in output from Y 1 to Y 2 raises aggregate real money demand which raises the interest rate to R 2. With Ee and R* fixed, the domestic currency must appreciate to E 2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 25

Short Run Equilibrium in Asset Markets (cont. ) • When income and output increase, Short Run Equilibrium in Asset Markets (cont. ) • When income and output increase, ¨ aggregate demand for real money increases, ¨ leading to an increase in domestic interest rates, ¨ leading to an appreciation of the domestic currency. • Similarly, when income and output decrease, the domestic currency depreciates. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26

Short Run Equilibrium in Asset Markets: AA Curve AA schedule: • shows combinations of Short Run Equilibrium in Asset Markets: AA Curve AA schedule: • shows combinations of output and the exchange rate at which the money market and foreign exchange market are in equilibrium. • slopes downward because a rise in output causes the exchange rate to fall (an appreciation of the domestic currency). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 27

Fig. 6: The AA Schedule The asset market equilibrium schedule (AA) slopes downward because Fig. 6: The AA Schedule The asset market equilibrium schedule (AA) slopes downward because a fall in output causes a fall in the home interest rate and a domestic currency depreciation. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 28

Shifting the AA Curve • Changes in the exchange rate cause movements along the Shifting the AA Curve • Changes in the exchange rate cause movements along the AA curve. Other changes cause it to shift: 1. Changes in Ms: an increase in the money supply reduces interest rates in the SR, causing the domestic currency to depreciate (a rise in E) for every output level (Y): the AA curve shifts up. • Figures 7 and 8 illustrate the impact of an increase in the money supply on the exchange rate and the AA curve. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 29

Fig. 7: Exchange Rate Effect of a Money Supply Increase with Fixed Output Exchange Fig. 7: Exchange Rate Effect of a Money Supply Increase with Fixed Output Exchange rate, E Decrease in return on domestic currency deposits 2' E 2 Return on domestic deposits 1' E 1 0 MS 1 P MS 2 P R 2 R 1 1 2 Domestic real money holdings Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Expected return on Domestic foreign deposits rates of return, L(R, Y 1) interest rate Domestic real money supply Increase in domestic money supply 30

Fig. 8: Outward Shift of the AA Curve Exchange rate, E E 4 c Fig. 8: Outward Shift of the AA Curve Exchange rate, E E 4 c E 3 An upward (outward) shift of the AA curve is shown by the movement from a to c and from b to d. a d E 2 b E 1 AA’ AA Y 1 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Y 2 Output, Y 31

Shifting the AA Curve (cont. ) 2. Changes in P: An increase in the Shifting the AA Curve (cont. ) 2. Changes in P: An increase in the domestic price level decreases the real money supply, increasing interest rates, causing the domestic currency to appreciate (a fall in E): the AA curve shifts down. 3. Changes in real money demand: if domestic residents prefer to hold a lower amount of real money balances, interest rates would fall, leading to a depreciation of the domestic currency (a rise in E): the AA curve shifts up. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 32

Shifting the AA Curve (cont. ) 4. Changes in R*: An increase in the Shifting the AA Curve (cont. ) 4. Changes in R*: An increase in the foreign interest rate makes foreign currency deposits more attractive, leading to a depreciation of the domestic currency (a rise in E): the AA curve shifts up. 5. Changes in Ee: if market participants expect the domestic currency to depreciate in the future, foreign currency deposits become more attractive, causing the domestic currency to depreciate (a rise in E): the AA curve shifts up. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 33

Putting the Pieces Together: the DD and AA Curves • A SR equilibrium means Putting the Pieces Together: the DD and AA Curves • A SR equilibrium means a nominal exchange rate and level of output such that: 1. equilibrium in the output market holds: aggregate demand equals aggregate output. 2. equilibrium in the foreign exchange market holds: interest parity holds. 3. equilibrium in the money market holds: the quantity of real money supplied equals the quantity of real money demanded. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 34

Fig. 9: SR Equilibrium: The Intersection of DD and AA The SR equilibrium of Fig. 9: SR Equilibrium: The Intersection of DD and AA The SR equilibrium of the economy occurs at point 1 where the output market (whose equilibrium points are summarized by the DD curve) and asset markets (whose equilibrium points are summarized by the AA curve) simultaneously clear. This is a SR equilibrium because output prices are fixed along the DD and AA curves. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 35

How the Economy Reaches Its SR Equilibrium • Why must E 1 be the How the Economy Reaches Its SR Equilibrium • Why must E 1 be the SR equilibrium exchange rate in Fig. 10? • If the exchange rate is E 2, then E is expected to fall in the future so there is an excess demand for domestic currency in the foreign exchange market. • The high level of E 2 also makes domestic goods cheap foreigners, so there is excess demand for domestic output. • Excess demand for domestic currency causes an immediate fall in the exchange rate from E 2 to E 3. • At point 3, the asset markets are in equilibrium but there is still an excess demand for goods. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 36

How the Economy Reaches Its SR Equilibrium (cont. ) • As firms raise their How the Economy Reaches Its SR Equilibrium (cont. ) • As firms raise their output, the economy travels along AA to point 1 where aggregate demand supply are equal at E 1. • Because assets prices can jump immediately while changes in production take time, the asset markets remain in equilibrium even while output is increasing. • E falls from point 3 to point 1 because rising output causes money demand to increase, pushing the interest rate up and thereby causing the domestic currency to appreciate. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 37

Fig. 10: How the Economy Reaches Its SR Equilibrium If the exchange rate is Fig. 10: How the Economy Reaches Its SR Equilibrium If the exchange rate is above its equilibrium level at E 2, then there is an excess demand for domestic currency and an excess demand for domestic output. There is an immediate fall in the exchange rate from E 2 to E 3 to keep asset markets in equilibrium. Firms respond to the excess demand by raising their production. As output rises, aggregate real money demand increases which raises interest rates and causes the domestic currency to appreciate from E 3 to E 1. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 38

Temporary Changes in Monetary and Fiscal Policy • Monetary policy: policy in which the Temporary Changes in Monetary and Fiscal Policy • Monetary policy: policy in which the central bank influences the supply of money. ¨ Monetary policy is assumed to affect asset markets first. • Fiscal policy: policy in which governments influence the amount of government purchases and taxes. ¨ Fiscal policy is assumed to affect aggregate demand output first. • Temporary policy changes are expected to be reversed in the near future and thus do not affect the LR expected exchange rate, Ee. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 39

Temporary Changes in Monetary Policy • An increase in the quantity of money supplied Temporary Changes in Monetary Policy • An increase in the quantity of money supplied lowers interest rates in the SR, causing the domestic currency to depreciate (a rise in E). ¨ The AA curve shifts up. ¨ Domestic products relative to foreign products are cheaper so that aggregate demand output increase until a new SR equilibrium is achieved. ¨ This is shown in Fig. 11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 40

Fig. 11: Effects of a Temporary Increase in the Money Supply An increase in Fig. 11: Effects of a Temporary Increase in the Money Supply An increase in the MS at fixed prices will cause the interest rate to fall and the domestic currency to depreciate. This shifts the AA curve up. The currency depreciation increases aggregate demand causes output to rise. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 41

Temporary Changes in Fiscal Policy • An increase in government purchases or a decrease Temporary Changes in Fiscal Policy • An increase in government purchases or a decrease in taxes increases aggregate demand output in the SR. ¨ The DD curve shifts out. ¨ Higher output increases real money demand, ¨ thereby increasing interest rates, ¨ causing the domestic currency to appreciate (a fall in E). ¨ This is shown in Fig. 12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 42

Fig. 12: Effects of a Temporary Fiscal Expansion A one-time increase in government spending Fig. 12: Effects of a Temporary Fiscal Expansion A one-time increase in government spending raises aggregate demand therefore output (Y 1 to Y 2). This raises the demand for real money balances which pushes interest rates up. Higher interest rates lead to an appreciation of the domestic currency (E 1 to E 2). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 43

Policies to Maintain Full Employment • Resources used in the production process can be Policies to Maintain Full Employment • Resources used in the production process can be over-employed or underemployed. • When resources are used effectively and sustainably, economists say that production is at its potential or full -employment level. ¨ When resources are not used effectively, resources are underemployed: high unemployment, few hours worked, idle equipment, lower than normal production of goods and services. ¨ When resources are not used sustainably, labor is overemployed: low unemployment, many overtime hours, overutilized equipment, higher than normal production of goods and services. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 44

Fig. 13: Maintaining Full Employment After a Temporary Fall in World Demand A temporary Fig. 13: Maintaining Full Employment After a Temporary Fall in World Demand A temporary fall in world demand shifts DD inward reducing output below full employment and causing the currency to depreciate from E 1 to E 2. Temporary fiscal expansion can restore full employment by shifting DD back to its original position. Temporary monetary expansion can restore full employment by shifting AA up. The fiscal policy restores the currency to its previous value (E 1) while the monetary policy causes a further depreciation from E 2 to E 3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 45

Fig. 14: Policies to Maintain Full Employment After an Increase in Money Demand A Fig. 14: Policies to Maintain Full Employment After an Increase in Money Demand A temporary increase in the demand for money pushes up the interest rate and appreciates the currency, thereby making domestic goods more expensive and causing output to contract. AA shifts down which lowers output below its full-employment level. A temporary money supply increase would shift AA back to its original position and restore full employment. Temporary fiscal expansion shifts DD out and restores full employment. However, it also causes a further appreciation of the currency from E 2 to E 3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 46

Policies to Maintain Full Employment (cont. ) • Policies to maintain full employment may Policies to Maintain Full Employment (cont. ) • Policies to maintain full employment may seem easy in theory, but are hard in practice. 1. We have assumed that prices and expectations do not change, but people may anticipate the effects of policy changes and modify their behavior. ¨ Workers may require higher wages if they expect overtime and easy employment, and producers may raise prices if they expect high wages and strong demand due to expansionary monetary and fiscal policies. ¨ Fiscal and monetary policies may therefore create price changes and inflation thereby preventing gains in output and employment: inflationary bias Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 47

Policies to Maintain Full Employment (cont. ) 2. Economic data are difficult to measure Policies to Maintain Full Employment (cont. ) 2. Economic data are difficult to measure and to interpret. ¨ It’s difficult for policy makers to know if a disturbance to the economy originates in the output or asset markets. This is important in choosing between monetary and fiscal policies. 3. Changes in fiscal policy takes time to be implemented and to affect the economy. ¨ To avoid procedural delays, governments may respond to disturbances by using monetary policy even when fiscal policy is more appropriate. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 48

Permanent Changes in Monetary and Fiscal Policy 4. Policies are sometimes influenced by political Permanent Changes in Monetary and Fiscal Policy 4. Policies are sometimes influenced by political or bureaucratic interests. • • Tax cuts or spending increases may be used to help win elections without regard to the business cycle. “Permanent” policy changes are those that are assumed to modify people’s expectations about exchange rates in the LR. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 49

Permanent Changes in Monetary Policy • A permanent increase in the quantity of money Permanent Changes in Monetary Policy • A permanent increase in the quantity of money supplied: ¨ lowers interest rates in the SR and makes people expect future depreciation of the domestic currency, increasing the expected rate of return on foreign currency deposits. ¨ The domestic currency depreciates more than (E rises more than) the case when expectations are held constant. ¨ The AA curve shifts up more than the case when expectations are held constant. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 50

Fig. 15: SR Effects of a Permanent Increase in the Money Supply A permanent Fig. 15: SR Effects of a Permanent Increase in the Money Supply A permanent increase in MS causes the expected future exchange rate (Ee) to rise proportionally. So the upward shift of AA is greater than that caused by an equal but temporary increase in MS which does not alter Ee. Point 3 shows the equilibrium that might result from a temporary increase in MS. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 51

Effects of Permanent Changes in Monetary Policy in the LR • With employment and Effects of Permanent Changes in Monetary Policy in the LR • With employment and hours above their normal levels, there is a tendency for wages to rise over time. • With strong demand for goods and services and with increasing wages, producers have an incentive to raise prices over time. • Both higher wages and higher output prices are reflected in a higher price level. • Fig. 16 illustrates the effects of rising prices. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 52

LR Adjustment to a Permanent Increase in the Money Supply • The SR equilibrium LR Adjustment to a Permanent Increase in the Money Supply • The SR equilibrium is at point 2 in Fig. 16 where output is above full employment. • Productive factors are working overtime and the price level is rising to keep up with rising production costs. • Domestic goods are becoming more expensive than foreign goods which lowers aggregate demand shifts DD in. • The rising price level also lowers the real money supply which shifts the AA curve in. • Both curves stop shifting inward only when they intersect at full employment (point 3). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 53

LR Adjustment to a Permanent Increase in the Money Supply (cont. ) • AA LR Adjustment to a Permanent Increase in the Money Supply (cont. ) • AA does not shift all the way back to its original position because Ee is permanently higher after the increase in MS. • Along the adjustment path between the SR (point 2) and LR equilibrium (point 3), the domestic currency appreciates from E 2 to E 3 following its initial sharp depreciation from E 1 to E 2. This is an example of exchange rate overshooting. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 54

Fig. 16: LR Adjustment to a Permanent Increase in the Money Supply After a Fig. 16: LR Adjustment to a Permanent Increase in the Money Supply After a permanent money supply increase, a steadily increasing price level shifts the DD and AA schedules inward until the new LR equilibrium is reached at point 3. A permanent increase in the money supply eventually causes all money prices to rise in proportion (including E, Ee, and P). However, it has no lasting effects on output, relative prices, or interest rates. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 55

Effects of Permanent Changes in Fiscal Policy • A permanent increase in government purchases Effects of Permanent Changes in Fiscal Policy • A permanent increase in government purchases or reduction in taxes ¨ increases aggregate demand ¨ makes people expect the domestic currency will appreciate in the SR due to increased aggregate demand, thereby reducing the expected rate of return on foreign currency deposits and making the domestic currency appreciate. • The increase in G raises aggregate demand for domestic products, but the subsequent currency appreciation lowers aggregate demand for domestic products (by making exports more expensive). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 56

Effects of Permanent Changes in Fiscal Policy (cont. ) • If the rise in Effects of Permanent Changes in Fiscal Policy (cont. ) • If the rise in G is permanent, then the fall in net exports exactly offsets the increase in G, so that output remains at its full-employment level. • We say that an increase in government purchases completely crowds out net exports, due to the effect of the appreciated domestic currency. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 57

Fig. 17: Effects of a Permanent Fiscal Expansion A permanent increase in G causes Fig. 17: Effects of a Permanent Fiscal Expansion A permanent increase in G causes a LR appreciation of the currency. The resulting fall in Ee shifts AA down. Point 2 is the SR equilibrium where the currency has appreciated from E 1 to E 2 and output remains unchanged at Yf. By contrast, a comparable temporary increase in G would leave the economy at point 3 (with higher output). A temporary change in G does not alter Ee and therefore does not shift AA. Note that prices (P) do not change because MS and L(R, Y) do not change. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 58

Macroeconomic Policies and the Current Account • To determine the effect of monetary and Macroeconomic Policies and the Current Account • To determine the effect of monetary and fiscal policies on the current account, ¨ derive the XX curve to represent the combinations of output and exchange rates at which the current account is at its desired level. • As income from production increases, imports increase and the current account decreases when other factors remain constant. • To keep the current account at its desired level, the domestic currency must depreciate as income from production increases: the XX curve should slope upward. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 59

Fig. 18: How Macroeconomic Policies Affect the CA Along XX, the CA is constant Fig. 18: How Macroeconomic Policies Affect the CA Along XX, the CA is constant and equal to a desired level, X. Temporary monetary expansion shifts AA out and moves the economy to point 2 and thus raises the CA balance. Temporary fiscal expansion shifts DD out and moves the economy to point 3. Permanent fiscal expansion shifts DD out and AA in and moves the economy to point 4. The CA balance falls with any fiscal expansion. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 60

Macroeconomic Policies and the Current Account (cont. ) • The XX curve slopes upward Macroeconomic Policies and the Current Account (cont. ) • The XX curve slopes upward but is flatter than the DD curve. ¨ DD represents equilibrium values of aggregate demand domestic output. ¨ As domestic income and production increase, domestic saving increases, which means that aggregate demand (willingness to spend) by domestic residents does not rise as rapidly as income and production. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 61

Macroeconomic Policies and the Current Account (cont. ) ¨ As domestic income and production Macroeconomic Policies and the Current Account (cont. ) ¨ As domestic income and production increase, the domestic currency must depreciate to entice foreigners to increase their demand for domestic products in order to keep the current account (only one component of aggregate demand) at its desired level—on the XX curve. ¨ As domestic income and production increase, the domestic currency must depreciate more rapidly to entice foreigners to increase their demand for domestic products in order to keep aggregate demand (by domestic residents and foreigners) equal to production—on the DD curve. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 62

Macroeconomic Policies and the Current Account (cont. ) • Policies affect the current account Macroeconomic Policies and the Current Account (cont. ) • Policies affect the current account through their influence on the value of the domestic currency. ¨ An increase in the quantity of money supplied depreciates the domestic currency and often increases the current account in the SR. ¨ An increase in government purchases or decrease in taxes appreciates the domestic currency and often decreases the current account in the SR. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 63

Value Effect, Volume Effect, and the J-curve • If the volume of imports and Value Effect, Volume Effect, and the J-curve • If the volume of imports and exports is fixed in the SR, a depreciation of the domestic currency ¨ will not affect the volume of imports or exports, ¨ but will increase the value/price of imports in domestic currency and decrease the current account: CA ≈ EX – IM. ¨ The value of exports in domestic currency does not change. • The current account could immediately decrease after a currency depreciation, then increase gradually as the volume effect begins to dominate the value effect. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 64

Fig. 19: The J-Curve volume effect dominates value effect Immediate effect of real depreciation Fig. 19: The J-Curve volume effect dominates value effect Immediate effect of real depreciation on the CA J-curve: value effect dominates volume effect Six months to one year Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 65

Value Effect, Volume Effect, and the Jcurve (cont. ) • Pass through from the Value Effect, Volume Effect, and the Jcurve (cont. ) • Pass through from the exchange rate to import prices measures the percentage by which import prices change when the value of the domestic currency changes by 1%. • In the DD-AA model, the pass through rate is 100%: import prices in domestic currency exactly match a depreciation of the domestic currency. • In reality, pass through may be less than 100% due to price discrimination in different countries. ¨ E. g. , foreign firms selling in the U. S. may not want to raise their U. S. prices by 10% when the dollar depreciates by 10% because they do not want to lose market share. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 66

Value Effect, Volume Effect, and the Jcurve (cont. ) • If prices of foreign Value Effect, Volume Effect, and the Jcurve (cont. ) • If prices of foreign products in domestic currency do not change much because of a pass through rate less than 100%, then the ¨ value of imports will not rise much after a domestic currency depreciation, and the current account will not fall much, making the J-curve effect smaller. ¨ volume of imports and exports will not adjust much over time since domestic currency prices do not change much. • Pass through of less than 100% dampens the effect of depreciation or appreciation on the current account. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 67