Chapter 17
Output and the Exchange Rate in the
Short Run
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17.1 Explain the role of the real exchange rate in determining the aggregate demand for a country’s output.
17.2 See how an open economy’s short-run equilibrium can be analyzed as the intersection of an asset market
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17.3 Understand how monetary and fiscal policies affect the exchange rate and national output in the short run. Learning Objectives (2 of 2)
17.4 Describe and interpret the long-run effects of permanent macroeconomic policy changes.
17.5 Explain the relationship among macroeconomic policies, the current account balance, and the exchange rate.
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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 Add
• Adjustment of the current account over time
• IS-LM model
Introduction
• Long-run models are useful when all prices of inputs and outputs have time to adjust.
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• This chapter builds on the short-run and long-run models of exchange rates to explain how output is related to exchange rates in the short run.
– It shows how macroeconomic policies can affect production, employment, and the current account.
(1 of 3)
• Aggregate demand is the aggregate amount of goods and services that individuals and institutions are willing to buy:
1. consumption expenditure
2. investment expenditure
3. government purchasesAdd
4. net expenditure by foreigners: the current account (1 of 3)
• Determinants of consumption expenditure include:
– Disposable income: income from production (Y) minus taxes
(T).
– More disposable income means more consumption expenditure, but consumption typically increases less than the amount that disposable income increases.
• Determinants of the current account include: – Real exchange rate: prices of foreign products relative to
the prices of domestic products, both measured in 𝐸𝑃∗ domestic
currency:
𝑃
▪ As the prices of foreign products rise relative to those of domestic products, expenditure on domestic Add products rises, and expenditure on foreign products falls.
– Disposable income: more disposable income means more expenditure on foreign products (imports).
Table 17.1 Factors Determining the Current Account
Change Effect on Current Account, CA
EP*
Real exchange rate, start fraction E P asterisk over P end fraction upward arrow CAC A upward arrow P
Real exchange rate, start fraction E P asterisk over P end fraction downward arrowEP* CAC A downward arrow
P
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Disposable income, YY super d upward arrowd CAC A downward arrow Disposable income, YY super d downward arrowd CAC A upward arrow
How Real Exchange Rate Changes Affect the Current Account (1 of 2)
• The current account measures the value of exports relative to the value of imports: CA EX IM.
EP*
– When the real exchange rate rises, the prices
P
of foreign products rise relative to the prices of domestic products. 1. The volume of exports that are bought by foreigners rises.
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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.
How Real Exchange Rate Changes Affect the Current Account (2 of 2)
• However, evidence indicates that for most countries the volume effect dominates the value effect after 1 year or less.Add
• Let’s assume for now that a real depreciation leads to an increase in the current account: the volume effect dominates the value effect.
Figure 17.1 Aggregate Demand as a
Function of Output
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EP *
Aggregate demand is a function of the real exchange rate , disposable
P
income (Y T ), investment demand (I), and government spending (G). If all
other factors remain unchanged, a rise in output (real income), Y, increases aggregate demand. Because the increase in aggregate demand is less than the increase in output, the slope of the aggregate demand function is less than 1 (as indicated by its position within the 45-degree angle).
(1 of 4)
• Determinants of the current account include: – Real exchange rate: an increase in the real
exchange rate increases the current account. – Disposable income: an increase in the disposable income decreases the current account.
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(2 of 4)
• For simplicity, we assume that exogenous political factors determine government purchases G and the level of taxes T.
• For simplicity, we currently assume that investment expenditure I is determined by exogenous business decisions.
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– A more complicated model shows that investment depends on the cost of spending or borrowing to finance investment: the interest rate.
(3 of 4)
• Aggregate demand is therefore expressed as:
P
– where C Y T is consumption expenditure as a function of disposable income,
– I + G is investment expenditure and government purchases (both
exogenous), and Add
– CA EP ,Y T is the current account as a function of the real P exchange rate and disposable income.
EP
• Or more simply:
(4 of 4)
• Determinants of aggregate demand include: – Real exchange rate: an increase in the real exchange rate
increases the current account, and therefore increases aggregate demand of domestic products.
– Disposable income: an increase in the disposable income increases consumption expenditure, but decreases the current account.
▪ Since consumption expenditure is usually greater than Add expenditure on foreign products, the first effect dominates the second effect.
▪ As income increases for a given level of taxes, aggregate consumption expenditure and aggregate demand increase by less than income.
Short-Run Equilibrium for Aggregate
Demand and Output
• Equilibrium is achieved when the value of output and income from production Y equals the value of aggregate demand D
Y ttps://.com,Y T I
G, ,
– where aggregate demand is a function of the real Add exchange rate, disposable income, investment expenditure, and government purchases.
Figure 17.2 The Determination of Output in the Short Run
In the short run, output settles at Y1 (point 1), where aggregate demand, D1, equals aggregate output, Y1.
• How does the exchange rate affect the short-run equilibrium of aggregate demand and output?
• With fixed domestic and foreign levels of average prices, 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 Add depreciation) increases aggregate demand of domestic products. • In equilibrium, production will increase to match the higher aggregate demand.
Figure 17.3 Output Effect of a Currency Depreciation with Fixed Output Prices
A rise in the exchange rate from E E1 to 2 (a currency depreciation) raises aggregate demand to Aggregate demand (E2) and output to Y2, all else equal.
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• shows combinations of output and the exchange rate at which the output market is in short-run equilibrium (such that aggregate demand = aggregate output).
• slopes upward because a rise in the exchange rate causes aggregate demand and aggregate output to rise.Add
Shifting the DD Curve (1 of 3)
• Changes in the exchange rate cause movements along a DD curve. Other changes cause it to shift:
1. Changes in G: more government purchases cause higher aggregate demand and output in equilibrium.
Output increases for every exchange rate: the DD curve shifts right. Add
2. Changes in T: lower taxes generally increase consumption expenditure, increasing aggregate demand and output in equilibrium for every exchange rate: the DD curve shifts right.
Figure 17.5 Government Demand and the
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A rise in government demand from G G1 to 2 raises output at every level of the exchange rate. The change therefore shifts DD to the right.
Shifting the DD Curve (2 of 3)
3. Changes in I: higher investment expenditure shifts the DD curve right.
4. Changes in P: higher domestic prices make domestic output more expensive compared to foreign output and reduce net export demand, shifting the DD curve left.
5. Changes in P*: higher foreign prices make domestic output less expensive compared to foreign output and Add increase net export demand, shifting the DD curve right.
Shifting the DD Curve (3 of 3)
6. Changes in C: willingness to consume more and save less shifts the DD curve right.
7. Changes in demand of domestic goods relative to foreign goods: willingness to consume more domestic goods relative to foreign goods shifts the DD curve right.
Add Short-Run Equilibrium in Asset Markets (1 of 2)
• Consider two sets of asset markets:
1. Foreign exchange markets
E Ee
– interest parity represents equilibrium: R R
E
2.Money market
– Equilibrium occurs when the quantity of real monetary assets supplied matches the quantity of real monetaryAdd
MS assets
demanded: L RY , P
– A rise in income from production causes the demand of real monetary assets to increase.
Figure 17.6 Output and the Exchange Rate in Asset Market Equilibrium
For the asset (foreign exchange and money) markets to remain in equilibrium, a rise in output must be accompanied by an appreciation of the currency, all else equal. Short-Run Equilibrium in Asset Markets (2 of 2)
• When income and production increase,
– demand of real monetary assets increases,
– leading to an increase in domestic interest rates,
– leading to an appreciation of the domestic currency.
• Recall that an appreciation of the domestic currency is represented by a fall in EAdd . • When income and production decrease, the domestic currency depreciates and E rises.
Short-Run Equilibrium in Asset Markets: AA Curve
• The inverse relationship between output and exchange rates needed to keep the foreign exchange markets and the money market in equilibrium is summarized as the AA curve.
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(1 of 3)
1. Changes in Ms : an increase in the money supply reduces interest rates in the short run, causing the
domestic currency to depreciate (a rise in E ) for every Y: the AA curve shifts up (right).
2. Changes in P: An increase in the level of average
domestic prices decreases the supply of real monetary Add
assets, increasing interest rates, causing the domestic currency to appreciate (a fall in E): the AA curve shifts
down (left).
(2 of 3)
3. 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 (right).
4. Changes in R * : An increase in the foreign interest Add rates makes foreign currency deposits more attractive, leading to a depreciation of the domestic currency (a
rise in E): the AA curve shifts up (right).
(3 of 3)
5. Changes in the demand of real monetary assets: if domestic residents are willing to hold a lower amount of
real money assets and more non-monetary assets,
interest rates on nonmonetary assets would fall, leading to a depreciation of the domestic currency (a rise in
E):
the AA curve shifts
up (right). Add
Putting the Pieces Together: the DD and AA
Curves (1 of 2)
• A short-run equilibrium means a nominal exchange rate and level of output such that
1. equilibrium in the output markets holds: aggregate demand equals aggregate output. 2. equilibrium in the foreign exchange markets holds:
interest parity holds. Add
3. equilibrium in the money market holds: the quantity of real monetary assets supplied equals the quantity of real monetary assets demanded.
Putting the Pieces Together: the DD and AA
Curves (2 of 2)
• A short-run equilibrium occurs at the intersection of the D D and AA curves:
– output markets are in equilibrium on the DD curve
– asset markets are in equilibrium on the AA curve
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Figure 17.8 Short-Run Equilibrium: The Intersection of DD and AA
The short-run equilibrium of the economy occurs at point 1, where the output market (whose equilibrium points are summarized by the DD curve) and the asset market (whose equilibrium points are summarized by the AA curve) simultaneously clear.
Figure 17.9 How the Economy Reaches Its ShortRun Equilibrium
Because asset markets adjust very quickly, the exchange rate jumps immediately from point 2 to point 3 on AA. The economy then moves to point 1 along AA as output rises to meet aggregate demand.
Temporary Changes in Monetary and Fiscal Policy
• Monetary policy: policy in which the central bank influences the supply of monetary assets.
– Monetary policy is assumed to affect asset markets first.
• Fiscal policy: policy in which governments
(fiscal authorities) influence the amount of government purchases and taxes.
– Fiscal policy is assumed to affect aggregate demand and Add output first.
• Temporary policy changes are expected to be reversed in the near future and thus do not affect expectations about exchange rates in the long run.
Temporary Changes in Monetary Policy
• An increase in the quantity of monetary assets supplied lowers interest rates in the short run, causing the domestic currency to depreciate (E rises).
– The AA shifts up (right).
– Domestic products relative to foreign products are cheaper, so that aggregate demand and output increase until a new short-run equilibrium is achieved.Add
Figure 17.10 Effects of a Temporary Increase in the Money Supply
By shifting AA1 upward, a temporary increase in the money supply causes a currency depreciation and a rise in output.
Temporary Changes in Fiscal Policy
• An increase in government purchases or a decrease in taxes increases aggregate demand and output in the short run.
– The DD curve shifts right.
– Higher output increases the demand for real monetary assets,
▪ thereby increasing interest rates,Add
▪ causing the domestic currency to appreciate
(E falls).
Figure 17.11 Effects of a Temporary Fiscal Expansion
By shifting DD1 to the right, a temporary fiscal expansion causes a currency appreciation and a rise in output.
Policies to Maintain Full Employment (1 of 3)
• Resources used in the production process can either be overemployed or underemployed.
• When resources are used effectively and sustainably, economists say that production is at its potential or natural 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.
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– When resources are not used sustainably, labor is overemployed: low unemployment, many overtime hours, overutilized equipment, higher than normal production of goods and services. Figure 17.12 Maintaining Full Employment after a Temporary Fall in
World Demand for Domestic Products
fiscal policy restores the currency to its previous value (E1)whereas the monetary, policy causes the currency to
depreciate further, to E3.
Figure 17.13 Policies to Maintain Full
Employment After a Money Demand Increase
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After a temporary money demand increase (shown by the shift from AA AA1 to 2), either an increase in the money supply or temporary fiscal expansion can be used to maintain full employment. The two policies have different exchange rate effects: The monetary policy restores the exchange rate back to E1, whereas the fiscal policy leads to greater appreciation E3 .
Policies to Maintain Full Employment (2 of 3)
Policies to Maintain Full Employment (3 of 3)
2. Economic data are difficult to measure and to understand. – Policy makers cannot interpret data about asset markets and aggregate demand with certainty, and sometimes they make mistakes.
3. Changes in policies take time to be implemented and to affect the economy.
Permanent Changes in Monetary and
Fiscal Policy
• “Permanent” policy changes are those that are assumed to modify people’s expectations about exchange rates in the long run.
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Permanent Changes in Monetary Policy
• A permanent increase in the quantity of monetary assets supplied has several effects: – It lowers interest rates in the short run and makes people expect future depreciation of the domestic currency, increasing the expected rate of return on foreign currency deposits.
– The domestic currency depreciates (Add E rises) more than is the case when expectations are constant (Econ Chapter 14/Finance Chapter 3 results). – The AA curve shifts up (right) more than is the case when expectations are held constant.
Figure 17.14 Short-Run Effects of a Permanent
Increase in the Money Supply
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A permanent increase in the money supply, which shifts AA AA1 to 2 and moves the economy from point 1 to point 2, has stronger effects on the exchange rate and output than an equal temporary increase, which moves the economy only to point 3.
Effects of Permanent Changes in Monetary Policy in the Long Run
• 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 Add in a higher level of average prices. • What are the effects of rising prices?
Figure 17.15 Long-Run 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 to the left until a new long-run equilibrium (point 3) is reached.
Effects of Permanent Changes in Fiscal Policy (1 of 2)
• A permanent increase in government purchases or reduction in taxes
• The first effect increases aggregate demand of domestic products, the second effect decreases aggregate demand of domestic products (by making them more expensive).
Effects of Permanent Changes in Fiscal Policy (2 of 2)
• If the change in fiscal policy is expected to be permanent, the first and second effects exactly offset each other, so that output remains at its potential or natural (or long run) level.
Add Figure 17.16 Effects of a Permanent Fiscal Expansion
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Because a permanent fiscal expansion changes exchange rate expectations, it shifts AA1 leftward as it shifts DD1 to the right. The effect on output
(point 2) is nil if the economy starts in long-run equilibrium. A comparable temporary fiscal expansion, in contrast, would leave the economy at point 3.
Macroeconomic Policies and the Current Account
(1 of 4)
• 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 Add 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.
Figure 17.17 How Macroeconomic Policies Affect the Current Account
Along the curve XX, the current account is constant at the level CA = X. Monetary expansion moves the economy to point 2 and thus raises the current account balance. Temporary fiscal expansion moves the economy to point 3, while permanent fiscal expansion moves it to point 4; in either case, the current account balance falls.
(2 of 4)
• The XX curve slopes upward but is flatter than the DD curve.
– DD represents equilibrium values of aggregate demand and domestic output.
– As domestic income and production increase, domestic saving increases, which means that aggregate demand (willingness to spend) Add by domestic residents does not rise as rapidly as income and production.
Macroeconomic Policies and the Current Account
(3 of 4)
– As domestic income and production increase, the domestic currency must depreciate to entice foreigners to
increase their demand of 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
Add foreigners to increase their demand of domestic products in order to keep aggregate demand (by domestic residents and foreigners) equal to production—on the DD curve.
(4 of 4)
• Policies affect the current account through their influence on the value of the domestic currency. – An increase in the quantity of monetary assets supplied depreciates the domestic currency and often increases the current account in the short run.
– An increase in government purchases or decrease in taxes appreciates the domestic currency and often Add decreases the current account in the short run. Value Effect, Volume Effect, and the
J-Curve (1 of 3)
• If the volume of imports and exports is fixed in the short run, 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.
Add – 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.
Figure 17.18 The J-Curve
The J-curve describes the time lag with which a real currency depreciation improves the current account. Value Effect, Volume Effect, and the
J-Curve (2 of 3)
• 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.
J-Curve (3 of 3)
• 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.
– the volume of imports and exports will not adjust much Add 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.
Global Value Chains and Exchange Rate Effects of Export and Import Prices
• Some imported intermediate goods become part of goods that are exported, leading to complex global value chains in which multiple countries produce portions of the value added of final products.
• For many countries, imported value accounts for a significant portion of the gross value of exports (backward linkages).
• Backward and forward linkages tend to dampen the effects of currency depreciations by creating offsetting forces.
Imported value added can account for a significant fraction of the value of exports.
Source: OECD.
(1 of 3)
• During the Great Depression of the 1930s, the nominal interest rate hit zero in the United States, and the country found itself in a liquidity trap.
• Once an economy’s nominal interest rate falls to zero, a central bank experiences difficulty lowering it any further. – At negative nominal interest rates, people find holding money preferable to bonds.
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– Starting in 2014, some major central banks have pushed nominal interest rates into slightly negative territory.
(2 of 3)
• The dilemma facing a central bank when the economy is in a liquidity trap slowdown can be seen by considering the interest parity condition when the domestic interest rate R = 0,
R 0 R E E E* e / .
• Assume for the moment that the expected future exchange rate,
Ee,is fixed. Add
• Suppose the central bank raises the domestic money supply so as to depreciate the currency temporarily
– that is, to raise E today but return the exchange rate to the level Ee later. (3 of 3)
• The interest parity condition shows that E cannot rise once R = 0 because the interest rate would have to become negative.
• Instead, despite the increase in the money supply, currency cannot depreciate further and the exchange rate remains steady at
E E eAdd / 1 R * .
• At an interest rate of R = 0, people are indifferent between bonds and money as both yield a zero nominal rate of return.
– An increase in the money supply has no effect on the economy!
Figure 17.20 A Low-Output Liquidity Trap
At point 1, output is below its full employment level. Because exchange rate expectations Ee are fixed, however, a monetary expansion will merely shift
AA to the right, leaving the initial equilibrium point the same. The horizontal stretch of AA gives rise to the liquidity trap.
(1 of 3)
1. Aggregate demand is influenced by disposable income and the real exchange rate.
2. The DD curve shows combinations of exchange rates and output where aggregate demand = aggregate output.
3. The AA curve shows combinations of exchange rates Add and output where the foreign exchange markets and money market are in equilibrium.
(2 of 3)
Summary
4. In the DD-AA model, we assume that a depreciation of the domestic currency leads to an increase in the current account and aggregate demand.
5. But reality is more complicated, and the
J-curve shows that the value effect at first dominates the volume effect.
Add (3 of 3)
6. A temporary increase in the money supply is predicted to increase output and depreciate the domestic currency.
7. A permanent increase does both to a larger degree in the short run, but in the long run output returns to its normal level.
8. A temporary increase in government purchases is predicted to increase output and appreciate the domestic currency.
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9. A permanent increase in government purchases is predicted to completely crowd out net exports, and therefore to have no effect on output.
Figure 17A1.1 Change in Output and Saving
Table 17A2.1 Estimated Price Elasticities for
International Trade in Manufactured Goods
