determinants of aggregate demand in an open economy
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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)
Slide 16-2
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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 increasesValue effect: we pay more in real terms (in units of domestic
product) for the imports we do buy when q increasesWe assume that the volume effect of a real exchange rate change
outweighs the value effect: q up CA “improves”.
Determinants of Aggregate Demand in an Open Economy
Slide 16-3
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Determinants of Aggregate Demand in an Open Economy
Factors Determining the Current Account
Slide 16-4
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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
Slide 16-5
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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)
Slide 16-6
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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
Slide 16-7
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Output Market Equilibrium in the Short Run: The DD Schedule
Output Effect of a Currency Depreciation with Fixed Output Prices
Output, Y
Aggregatedemand, D
45°
D = Y
1
Y1
Aggregate demand (E2)
Aggregate demand (E1)
Y2
2Currencydepreciates
Slide 16-8
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
Aggregate demand (E2)Aggregate demand (E1)
Y2
Output, Y
Exchange rate, E
Y1
1E1
E22
Slide 16-9
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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).
Output Market Equilibrium in the Short Run: The DD Schedule
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
E0 1DD2
Slide 16-11
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Foreign exchange market equilibrium (interest rate parity):R = R* + (Ee – E)/E
where: Ee is the expected future exchange rateR is the interest rate on domestic currency depositsR* is the interest rate on foreign currency deposits
Money Market equilibriumMs/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).
Slide 16-12
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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
2Output rises
Slide 16-13
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The AA Schedule: Y up E down (currency appreciation)
Output, Y
Exchange Rate, E
Asset Market Equilibrium in the Short Run: The AA Schedule
AA
Y1
E11
Y2
E22
Slide 16-14
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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 upForeign interest rate: R* up E up (depreciation)Real money demand: Ld up R up E down (appreciation)
Asset Market Equilibrium in the Short Run: The AA Schedule
Slide 16-15
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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
Slide 16-16
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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
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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
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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
Slide 16-19
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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
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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
Temporary Changes in Monetary and Fiscal Policy
Slide 16-21
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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
Temporary Changes in Monetary and Fiscal Policy
Slide 16-22
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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
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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
Slide 16-24
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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
Permanent Shifts in Monetary and Fiscal Policy
Slide 16-25
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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
E1 1
Permanent Shifts in Monetary and Fiscal Policy
Slide 16-26
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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
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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
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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).
Slide 16-29
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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
Slide 16-30
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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
Gradual Trade Flow Adjustment and Current Account Dynamics
Slide 16-31
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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.
Gradual Trade Flow Adjustment and Current Account Dynamics
Slide 16-32
Copyright © 2003 Pearson Education, Inc.
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
Copyright © 2003 Pearson Education, Inc.
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
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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
Slide 16-35
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R2
Figure 16AI-2: Effects of Permanent and Temporary Increases in the Money Supply in the IS-LM Model
Appendix I: The IS-LM Model and the DD-AA 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
Copyright © 2003 Pearson Education, Inc.
R2
Figure 16AI-3: Effects of Permanent and Temporary Fiscal Expansions in the IS-LM Model
Appendix I: The IS-LM Model and the DD-AA 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
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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
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Appendix III: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities Table 16AIII-1: Estimated Price Elasticities for International Trade
in Manufactured Goods
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