output and the exchange rate in the short run. introduction how can we analyze the short run of an...
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Output and the Exchange Rate in the Short Run
Introduction How can we analyze the short run of an
open economy? What are the impacts on a country’s
imports and exports from changes in the real exchange rate?
How much effect do changes in foreign trade have on growth rate of GDP?
What is the importance of the real exchange rate in an open economy?
Aggregate Demand Relationship between total quantity
demanded of goods and services in all sectors of the economy and the price level, holding all else constant
Total output of goods and services measured by real GDP – horizontal axis
Price level measured by GDP price deflator – vertical axis
AD curve slopes downward – as price level declines, quantity of goods demanded increases
Aggregate Demand Does not behave in the same
manner as an ordinary demand curve
Price of product falls Consumer’s real income rises –
increases amount consumed for normal good (income effect)
Lower price induces consumers to purchase more of product b/c cheaper (substitution effect)
Aggregate Demand Neither the income or substitution
effect are relevant to overall price level
If aggregate price level falls Prices consumers pay are falling Prices people receive as wages, rents,
etc. are also falling No change in demand
Aggregate Demand Price level is measure of prices in
general, not a particular price As price level falls there is no
substitution effect b/c prices in general are falling, not the price of a particular good.
Aggregate Demand Why is AD negatively sloped?
1. As price level changes, value of individual’s real wealth changes – wealth effect
Increase in price level: Reduces value of accumulated financial
assets Consumers reduce consumption of goods Aggregate quantity demanded changes
Aggregate Demand Why is AD negatively sloped? (cont.)
2. Rise in price level increases interest rates – interest rate effect
Lower business investment Lower consumer spending on housing and cars Aggregate quantity demanded falls
3. Price level changes impact country’s total exports and imports – international substitution effect
Aggregate Demand Why is AD negatively sloped? (cont.)
Price level increase Price of domestic goods rises relative to
foreign goods Foreign demand (exports) for domestic
goods decreases Domestic demand (imports) for foreign
goods increases Aggregate quantity demanded declines
Aggregate Demand All three effects lead to decreases
in aggregate quantity demanded (output of goods and services) as price level increases (all else equal)
The opposite is also true Inverse relationship is shown as
movement along aggregate demand curve
Aggregate Demand Curve
Changes in Aggregate Demand Changing one of the variables held
constant along the AD curve will cause a shift in the curve
Increases (decreases) in AD will shift the curve to the right (left)
New AD curve shows at any given price level, society wants to buy more (less) goods and services
Changes in Aggregate Demand Expenditure approach to calculating
GDP Look at the four sectors of an open
economy that buy real goods/services
)( IXGICGDP Changes in any above factors,
shifts AD
Changes in Aggregate Demand
Changes in Aggregate Demand
I. Consumption (C)A. Consumer wealth As consumer wealth increases
(decreases), level of consumption increases (decreases)
Increase (decreases) in consumption shifts AD curve to right (left)
Changes in Aggregate Demand
B. Consumer expectations More confident consumers are about
the future, more likely to consume today
Increased confidence increases AD (curve shifts right)
Reverse is also true
Changes in Aggregate Demand
C. Degree of consumer indebtedness High level of indebtedness from past
consumption financed by borrowing Must pay off existing dept May need to reduce current consumption Consumer spending falls AD curve shifts left
Reverse is also true
Changes in Aggregate Demand
D. Taxes Higher taxes (or lower transfer
payments) reduce society’s after tax income
Lower income leads to lower consumption spending
AD curve shifts left Reverse is also true
Changes in Aggregate Demand
II. Investment spendingA. Higher interest rates
Decreases business investment and public investment in housing
Aggregate demand decreases (shifts left) Opposite is also true
B. Expectations of future economic conditions
Current economic conditions affect expectations of future in same direction thereby affecting investment spending
Changes in Aggregate Demand
II. Investment spending (cont.)C. Government changes in
business taxation Increasing (decreasing) business
taxes raise (lower) investment spending and aggregate demand
Changes in Aggregate Demand
III. Government Spending Increasing in government spending
on goods/services, increases aggregate demand
Opposite is also true Government spending at federal,
sate or local level
Changes in Aggregate Demand
IV. Exports and ImportsA. Exports sensitive to changes in
income of foreign countries Increases in foreign incomes increase
exports which increases aggregate demand (and vice versa)
Faster foreign economic growth leads to greater changes in US aggregate demand
Slower foreign growth (recessions) negatively impacts US aggregate demand
Changes in Aggregate Demand
IV. Exports and Imports (cont.)B. Movements in real exchange rate As dollar depreciates
Foreign currency buys more US goods – increases exports
US currency buys fewer foreign goods – decreases imports
Aggregate demand increases Opposite is also true
Changes in Aggregate Demand
Aggregate Supply Relationship between the total
quantity of goods/services an economy produces at various price levels, holding all other determinant of production unchanged.
Slopes upward to the right As price level rises, quantity of goods
and services economy produces increases
Aggregate Supply Why is AS positively sloped?
Represents entire economy’s total production
Higher price level is necessary to bring a higher level of total production
Assume short run labor force, capital stock, stock of natural resources, and level of technology are constant
Aggregate Supply Why is AS positively sloped? (cont.)
Related to both rising demand for output and rising unit costs as economy moves closer to full employment
As output expands, prices of some inputs rise before economy reaches full employment leading to rising unit costs
As some prices rise while others are constant, price level on average increases before reaching full employment
Aggregate Supply Why is AS positively sloped? (cont.)
Most important price in economy is price of labor
Hiring more labor decreases K/L ratio MPL decreases and wage rate increases Leads to rising production costs
Rising price level means higher prices are necessary to increase total output – upward sloping AS curve
Aggregate Supply
Aggregate Supply Change in aggregate supply means per
unit production costs are rising (falling) for some reason unrelated to an increase in production (output)
Increases in AS will shift the curve to right At any given price level, firms are willing and
able to produce more goods/services Firms can produce same level of output at
lower unit costs – unit costs have declined
Changes in Aggregate Supply Decreases in AS will shift the curve
to the left Unit costs of production have increased
Two types of changes or shifts in AS Changes due to changes in potential
real GDP Changes in major determinants of AS
curve held constant along the curve
Changes in Aggregate Supply
Changes in Aggregate SupplyI. Changes in potential real GDP
A. Factors of production As factors of production (land, labor,
capital, entrepreneurial ability) increase over time, AS curve will shift right
B. Productivity of factors of production Increases in productivity reduce unit
costs and shift AS curve to right Synonymous with country’s long
run economic growth
Changes in Aggregate SupplyII. Determinants of aggregate supply
A. Input prices Increases in input prices increase costs
of production decreasing AS EX: increases in wages, oil shock
B. Exchange rate shock Large change in real value of a country’s
currency in short period of time Change change firm’s costs of
production changing aggregate supply
Changes in Aggregate Supply
II. Determinants of aggregate supplyC. Changes in business taxes
Increases in overall business taxes increases costs of production decreasing AS and vice versa
EX: sales taxes, excise taxes, payroll taxes
D. Public’s inflationary expectations Perceived increases in future inflation cause
adjustments in economic action today.
Changes in Aggregate Supply
D. Public’s inflationary expectations (cont.) Producers may attempt to increase
prices today to stay ahead of anticipated inflation
Workers attempt to receive larger salary increases today to protect real wages and standards of living
Aggregate supply curve will decrease (left shift)
Changes in Aggregate Supply
Aggregate Equilibrium Intersection of AS and AD determines
the open economy’s equilibrium Equilibrium level of real output (production
and spending) for economy at Ye
Equilibrium price level for the economy at Pe
Shifts in AS or AD will change equilibrium level of output and price level
Aggregate Equilibrium
Aggregate Equilibrium Note that changes in exchange rate
shift both AD and AS curves Changes in exchange rate can affect
an open economy’s equilibrium level of output and price level
Not only are trade flows (exports and imports) affected, but there are noticeable impacts on entire economy
Determinants of Current Account
Changes in AD and AS influence output We will focus on one component of
aggregate demand and supply – the current account
How does a change in the current account (exports minus imports) impacts the equilibrium level of output
Changes in other determinants of AD and AS will be ignored
Changes in Current AccountI. Exports
A. Level of income in foreign countries, Yf Exports change with changes in foreign
incomes Size of change determined by two factors1. Size of change in foreign income
Larger income changes have larger effects on exports
Changes in foreign income that affect a country’s exports are weighted averages of changes in income among the countries trading partners
Changes in Current Account
I. Exports (cont.)2. Income elasticity of demand for the
country’s exports Percentage change in a country’s
exports relative to the percentage change in foreign income
f
Yf Yin
Xin
%
%)(
Changes in Current Account
I. Exports (cont.)2. Income elasticity of demand for the
country’s exports Elasticity is a positive number As foreign incomes increase (decrease),
a country’s exports increase (decrease) Size of country’s foreign income
elasticity depends on product mix of a country’s exports
Changes in Current Account
I. Exports (cont.)2. Income elasticity of demand for the
country’s exports If a country exports a high percentage of
goods with high income elasticities of demand, they will tend to have a higher foreign income elasticity and vice versa
US close to 1, Germany and Japan greater than 1, Chile, South Africa less than 1
Changes in Current Account
I. Exports (cont.)B. Real exchange rate (RXR) As the real value of country’s currency
appreciates (depreciates, level of a country’s exports declines (increases)
Size of effect depends on1. Size of change in real exchange rate
The larger the change in RXR, the larger the effect on exports
Changes in Current Account
I. Exports (cont.)B. Real exchange rate (RXR)
2. Price elasticity of demand for exports Sensitivity of a country’s exports to
changes in the real exchange rate Sensitivity of a country’s exports is
inversely related to changes in real exchange rate
RXRin
XinRXR
%
%)(
Changes in Current Account
II. Imports A. Level of domestic income (Yd)
As domestic income rises, level of imports rises
Size of effect depends on two factors1. Size of change in domestic income2. Income elasticity of demand for imports
d
Yd Yin
Min
%
%)(
Changes in Current Account
II. Imports A. Level of domestic income (Yd)
2. Income elasticity of demand for imports (cont.)
Income elasticity is positive – increases in domestic income cause an increase in imports
May be equal to, greater than or less than 1
3. Real Exchange rate As currency appreciates, imports increase
Changes in Current Account
II. Imports 3. Real Exchange rate (cont.)
Magnitude of effect depends on two factors1. Size of change in real exchange rate – smaller
changes have smaller effects2. Price elasticity of demand for imports – percent
change in imports relative to percent change in real exchange rate – direct relationship
RXRin
MinPMR
%
%)(
Changes in Current Account
Effects on Open Economy AD is link between current account
balance and output Since real exchange rates effect
current account, we can link them to changes in domestic output
Effects on Open EconomyI. Exchange Rate Appreciation
Equilibrium exchange rate equates inflows and outflows of foreign exchange at XRe
Assume rate is associate with purchasing power parity (PPP)
Initial level of AD is also determined Assume no capital flows between countries,
foreign trade is balanced at FXe, and economy has equilibrium output of Ye
Effects on Open Economy
I. Exchange Rate AppreciationA. Assume real exchange rate changes
– currency appreciates to XR1 Assume caused by rightward shift of
supply of foreign exchange Exports would fall and imports would
rise resulting in a current account deficit
Equal to difference between M and X in figure 15.6 (a)
Effects on Open Economy
Effects on Open Economy Effects of current account deficit on
real economy1. Domestic economy’s AD will decrease as
exports fall and imports rise AD shifts to left (15.6 b) Equilibrium level of output (real GDP) falls
2. Price level falls as AD decreases Price of imports falls Price of US produced goods that compete with
imports may fall
Effects on Open Economy
Effects on Open Economy
II. Exchange Rate DepreciationA. Demand for foreign exchange increases
Assuming no capital flows, we are in balanced trade
Assume PPP exchange rate As exchange rate depreciates, current account
surplus would occur (M’ to X’) Exports increase as price of domestic goods
falls Imports decrease and domestic price of
imported goods increases
Effects on Open Economy
Effects on Open Economy Effects of current account surplus
on economy Economy’s aggregate demand
increase as exports increase and imports decrease
Domestic real GDP increases as total output increases
Country’s price level rises
Effects on Open Economy
Effects on Open Economy
III. Exchange Rate Shocks Assume a 75% depreciation of a
country’s currency in one week Demand for foreign exchange has
increased and supply has decreased Exchange rate goes from XRe to XR’’ Could have been capital flight out of
country due to domestic crisis or due to exchange rate being fixed at inappropriate level for long period of time
Effects on Open Economy
Effects on Open Economy
III. Exchange Rate Shocks (cont.) If depreciation is large, effects on AS can
be very large as well For an open economy, depreciation
causes a large short-run increases in costs of production
AS shifts left decreasing output significantly leading to recession
Price level increases significantly Common for developing countries
Effects on Open Economy
Effects on Composition of Output How does the composition of output
change in the long run due to changes in exchange rate?
Distinction between1. Tradeable goods – products commonly
sold in international markets2. Non-tradeable goods – goods for which
selling between countries is too costly
Effects on Composition of Output
Assume currency appreciates Open economy’s equilibrium output
and price level change Overall production of tradeable goods
falls Exports decline and imports rise
Decline in price of tradeable goods makes non-tradeable goods relatively more expensive
Effects on Composition of Output Resources will flow to industry with
higher prices – non-tradable industry If operating at full employment,
resources flow from sector that is declining to sector that is expanding
Positive effect on economy’s non-tradable goods sector
Occurred in US in early 1980’s as economy shifted production away from tradeable goods to non-tradeable goods
Effects on Composition of Output Opposite occurs when country’s currency
depreciates Prices in tradeable goods sector increase
and output of tradeable goods increases Exports increase and imports fall
Resources flow from production of non-tradeable goods to production of tradeable goods
Changes in real exchange rate can have critical impact on the mix of production in an economy