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ECON 671 – International Economics Aggregate Demand & Supply in the Open Economy

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Short Run IS-LM-BP Model and Aggregate Demand

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3 Open Economy SR Equilibrium: IS-LM-BP Model F IS-LM-BP Model described by 3 equations (IS) (IS) Y = C (Y-T, W) + I(i) + G + NX(e, Y, Y ROW, W) (LM) (LM) M s /P= a(DR + IR)/P= f(Y, i, W, E( )) (BP) (BP) BOP 0 = NX(e, Y, Y ROW, W) + (i, i*+ xa) Fixed Exchange Rate Regime F IS-LM-BP with Fixed Exchange Rate Regime: Endogenous VariablesY, i, MEndogenous Variables: Y, i, M (BOP= IR) Exogenous VariablesExogenous Variables: G, T, DR, W, P, e Flexible Exchange Rate Regime F IS-LM-BP with Flexible Exchange Rate Regime: Endogenous VariablesY, i, eEndogenous Variables: Y, i, e Exogenous VariablesExogenous Variables: G, T, M (BOP=0), W, P

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4 Effect of Domestic Price Level rise F Look at effects of rise in domestic prices, P. F Direct Effects –Rise in P lowers NX which shifts IS and BP Curves inwards. –Also lowers real money supply so LM Curve shifts back. –New internal equilibrium where new IS Curves intersect. u Y decreases at new intersection. This is new overall equilib.!! –This result occurs regardless of fixed or flexible EXR. F Aggregate Demand –AD Curve shows relationship between Domestic Price Level and Output for Open Economy. u Demonstrated this is downward-sloping regardless of EXR regime.

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5 Increase in Domestic Prices Interest Rate Income, Output LM(M s /P 0 ) IS(e 0, P 0 ) BP(e 0, P 0 ) IS(e 1, P 1 ) D P >0 BP(e 1, P 1 ) LM(M s /P 1 ) D P >0 Y0Y0 i0i0 Y1Y1

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6 Open Economy AD Curve Begin at Price Level P 1 with IS 1, BP 1, and LM * Increase Price level to P 2. - All 3 curves shift inward. 2. Lower level of real GDP, Y 2, at higher Price level P AD Curve summarizes relationship of P and Y. 4. Anything that shifts IS, BP, or LM Curve (with Price level fixed) will shift AD Curve. i i1i1 Y Y1Y1 BP 1 IS 1 Y1Y1 P2P2 1. Y Price Level P P1P1 AD(G,T,M,i*) 3. LM 1 Y2Y2 LM 2 2.BP 2 2. IS 2 2. Y2Y2 i2i2

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Shifts in Aggregate Demand under Different EXR Regimes

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8 AD Curve Shifts & Fixed EXR F Fiscal Policy –Shifts in IS Curve lead to shifts in AD Curve because Y changes. –Adjustments to equilibrium depend on degree of capital mobility. –Higher the degree of capital mobility, the more effective is fiscal policy. u When capital immobile, IR adjustment shifts LM in & increases i, Y fixed. u When capital mobile, IR adjustment shifts LM out & increases Y, i fixed. F Monetary Policy –Shifts in LM Curve do not affect AD curve because Y does not change. –Adjustment to equilibrium does not depend on degree of capital mobility. –Monetary policy is not effective in changing Y. u Change in Domestic Reserves brings changes in i & Y affecting FX market. u FX market disequilibrium, requires Central Bank to change Intl Reserves by amount exactly offsetting original change in Domestic Reserves. F Exchange Rate Policy –Devaluation shifts both IS & BP curves, increasing Y, shifts AD curve out. u Central Bank intervention to achieve new fixed EXR brings about change.

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9 AD Curve Shifts & Flexible EXR F Fiscal Policy –Shifts in IS affect AD Curve only to extent Y changes.. –How much shift in IS changes Y depends on degree of capital mobility. –Higher the degree of capital mobility, the less effective is fiscal policy. u When capital immobile, EXR adjustment mostly shifts BP & increases Y. u When capital mobile, EXR adjustment mostly shifts IS & decreases Y. F Monetary Policy –Shifts in LM Curve lead to shifts in AD Curve because Y changes. –Shift in AD Curve does not depend on degree of capital mobility. –Monetary policy is very effective in changing Y & shifting AD Curve. u Most effective when capital perfectly mobile, keeps domestic i = i*. u Effect on interest rate uncertain in most cases, depends on relative shifts and slopes of IS and BP curves.

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Short Run and Long Run Aggregate Supply

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11 Short Run Aggregate Supply F Use standard model of SRAS. All variations of this model have a common theme. (SRAS) Y = Y LR + (P- P e ) with > 0 F In SR, output deviates from LR level if actual price level deviates from expected price level. This behavior arises from imperfection in a market. Each of the four models focuses on slightly different rationale for imperfection. F These models imply a tradeoff between inflation and unemployment - but only a temporary one. Called the Phillips Curve

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12 Sticky Wage Model of SRAS F In labor market, nominal wage often sticky in SR. Why? Unions, long term contracts, social norms. F If nominal wage, W, assumed fixed then; Rise in Price level will reduce real wage, W/P. Labor cheaper, firms hire more labor, increase output. Higher Price level brings higher output = SRAS. F Nominal wage fixed by expected Price, P e. W = Target Real Wage x P e W = x P eBargain W = Target Real Wage x P e or W = x P e Actual real wage = W/P = x P e /P)Receive Actual real wage = W/P = x P e /P) P > P e lowerIf P > P e actual real wage lower than target real wage. Y = Y LR + (P- P e ) > 0 Leads to SRAS: Y = Y LR + (P- P e ) > 0

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13 Worker Misperception Model F In labor market assume Nominal wage varies but workers confuse real & nominal wages. L d = L d (W/P). F Firms know Price level: L d = L d (W/P). L s = L s (W/P e ) F Workers do not know Price level: L s = L s (W/P e ) L s = L s (W/P x P/P e )rewrite Labor Supply as L s = L s (W/P x P/P e ) L s depends on real wage & worker misperceptions of P. F Unexpected increase in Price Level increases P/P e. Any real wage now associated with higher nom. wage. Workers interpret as higher real wage. L s shifts out. Y = Y LR + (P- P e ) > 0 Leads to SRAS: Y = Y LR + (P- P e ) > 0

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14 Imperfect Information Model F Focus on misperceptions of price in output market. No-one in economy knows true average price level. Supplier observes only price of single good they sell. How much of price change in good due to inflation? How much from increase in relative demand? u If price change due to entirely inflation, real price unchanged –Supplier should not increase output., real profits same. u If price change from increased demand, real price increased. –Supplier should increase output because real profit higher. F Unexpected rise in price level for given expected price fools suppliers into increasing output. Y = Y LR + (P- P e ) > 0 Leads to SRAS: Y = Y LR + (P- P e ) > 0

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15 L Misperception Model of SRAS L L d (W/P) W/P Y Y Labor Market Aggregate Supply Production F(K 0, L) L1L1 L1L1 Y1Y1 Y1Y1 3. Higher L results in higher output Y. Y2Y2 3. Y2Y2 Y=Y LR + (P-P e ) Relationship between P and Y Summarized by upward sloping SRAS. (W/P) 1 P1P1 1. Increase in Price level fools workers. P2P2 1. LS1LS1 L2L2 2. Result is fall in Real wage, increase in L. L2L2 2. (W/P) 2 2. L S shifts out given workers fixed P e. LS2LS2

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16 Short Run Aggregate Supply Price Level P Income, Output, Y Y1Y1 LRAS 2. LRAS vertical P e = P in LR equilib. P1P1 1. SRAS upward sloping - depends on price expectations Y = Y LR + (P - P e 1 ) P e - increase in P e shifts SRAS up. P2P2 3. Change in expected price 1

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SR vs. LR Effects in an Open Economy AD-AS Model

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18 Shift in AD Curve: SR vs LR Price Level P Income, Output, Y LRAS P 1 LR SRAS 1 AD 1 3. P e - increase in P e shifts SRAS up. 3. Change in expected price SRAS 2 AD 2 1. AD Curve shifts out - Price expectations fixed 1. Y SR 2. In SR: Higher Y SR and P SR P SR 2. P 2 LR In LR: back to Y LR at higher Price level. Y LR

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