1. 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)
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2. Determinants of Aggregate Demand in an Open Economy
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 increases
Value effect: we pay more in real terms (in units of domestic product) for the imports we do buy when q increases
We assume that the volume effect of a real exchange rate change outweighs the value effect: q up  CA “improves”.
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3. Determinants of Aggregate Demand in an Open Economy
Factors Determining the Current Account
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4. The Equation of Aggregate Demand
Aggregate Demand as a Function of Output
Output (real income), Y
Aggregate
demand, D
Aggregate demand function,
D(EP*/P, Y – T, I, G)
45°
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5. Output market equilibrium in the short-run: The Keynesian Cross
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)
Output, Y
Aggregate
demand, D
Aggregate demand =
aggregate output, D = Y
Aggregate demand 3 Y3 D1 1 Y1 2 Y2
45°
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6. Output Market Equilibrium in the Short Run: The DD Schedule
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
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7. Output Market Equilibrium in the Short Run: The DD Schedule
Output Effect of a Currency Depreciation with Fixed Output Prices
Output, Y
Aggregate
demand, D
D = Y
Aggregate demand (E2)
Currency
depreciates Y2 2
Aggregate demand (E1) 1 Y1
45°
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8. 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
Aggregate demand (E2)
Aggregate demand (E1) Y2 Y1 Y1 Y2
Output, Y
Exchange rate, E DD E2 2 1 E1
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9. Output Market Equilibrium in the Short Run: The DD Schedule
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).
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10. Output Market Equilibrium in the Short Run: The DD Schedule
Government Demand and the Position of the DD Schedule
Output, Y
Aggregate demand, D
D = Y
D(E0P*/P, Y – T, I, G2)
Government
spending rises
Aggregate demand curves Y2
D(E0P*/P, Y – T, I, G1) Y1 Y1 Y2
Output, Y
Exchange rate, E
DD1
DD2 E0 1 2
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11. R = R* + (Ee – E)/E Ms/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).
Foreign exchange market equilibrium (interest rate parity):
R = R* + (Ee – E)/E
where: Ee is the expected future exchange rate
R is the interest rate on domestic currency deposits
R* is the interest rate on foreign currency deposits
Money Market equilibrium
Ms/P = L(R, Y)
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12. Y up  Ld up  R up  E down (currency appreciates)
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)
Real domestic money holdings
Domestic interest
rate, R
Exchange Rate, E
Foreign
exchange
market R2 E1 1' E2 2'
Domestic-currency
return on foreign-
currency deposits
Money
market 1 R1
L(R, Y1)
Output rises
L(R, Y2)
Real money
supply MS P 2
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13. The AA Schedule: Y up  E down (currency appreciation)
Asset Market Equilibrium in the Short Run: The AA Schedule
The AA Schedule: Y up  E down (currency appreciation)
Output, Y
Exchange
Rate, E AA Y1 E1 1 Y2 E2 2
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14. Asset Market Equilibrium in the Short Run: The AA Schedule
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 up
Foreign interest rate: R* up  E up (depreciation)
Real money demand: Ld up  R up  E down (appreciation)
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15. Short-Run Equilibrium: The Intersection of DD and AA
Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together
Short-Run Equilibrium: The Intersection of DD and AA
Output, Y
Exchange
Rate, E DD AA Y1 E1 1
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16. Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together
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
Output, Y
Exchange
Rate, E DD 2 E2 AA 3 E3 Y1 E1 1
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17. 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.
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18. Temporary Change in Monetary Policy
Temporary Increase in the Money Supply: R down  E up (depreciation) at each value of Y  AA shifts up
Output, Y
Exchange
Rate, E DD
AA2
AA1 Y2 E2 2 1 E1 Y1
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19. Temporary Change in Fiscal Policy
Temporary Fiscal Expansion: G up  Y increases at each value of E  DD shifts outward
Output, Y
Exchange
Rate, E
DD1
DD2 AA Y1 E1 1 2 Y2 E2
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20. Temporary Changes in Monetary and Fiscal Policy
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
DD2
AA2
DD1
AA1 Yf 3 E3 Y2 E2 2 1 E1
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21. Temporary Changes in Monetary and Fiscal Policy
Policies to Maintain Full Employment After Money-Demand Up (Money “shortage”  recession). So Increase G or Ms
Output, Y
Exchange
Rate, E
DD1
AA1
DD2
AA2 Yf 1 E1 Y2 E2 2 3 E3
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22. 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
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23. 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 Supply
expected 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, R
OVERSHOOTING
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24. Permanent Shifts in Monetary and Fiscal Policy
Short-Run Effects of a Permanent Increase in the Money Supply (E3 is newly expected long-run exchange rate)
Output, Y
Exchange
Rate, E
DD1
AA2 Yf
AA1 Y2 E2 2 3 1 E1
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25. Permanent Shifts in Monetary and Fiscal Policy
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
DD2
AA2 Yf
DD1
AA3
AA1 Y2 E2 2 3 E3 E1 1
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26. Permanent Fiscal Expansion
Expected Appreciation Shifts AA Down Immediately
No Change in Output, Even in Short-Run
Complete Crowding Out
Output, Y
Exchange
Rate, E
DD1
AA1
DD2
AA2 Yf 1 E1 3 2 E2
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27. 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.
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28. 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).
Output, Y
Exchange
Rate, E DD XX AA 2 Yf E1 1 3 4
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29. Gradual Trade Flow Adjustment and Current Account Dynamics
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.
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30. Gradual Trade Flow Adjustment and Current Account Dynamics
The J-Curve
Time
Current account (in
domestic output units)
Long-run
effect of real
depreciation
on the current
account 1 3 2
Real depreciation takes place and J-curve begins
End of J-curve
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31. Gradual Trade Flow Adjustment and Current Account Dynamics
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.
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32. 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.
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33. 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.
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34. Appendix I: The IS-LM Model and the DD-AA Model
Figure 16AI-1: Short-Run Equilibrium in the IS-LM Model
Output, Y
Interest
rate, R LM IS Y1 R1 1
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35. Appendix I: The IS-LM Model
and the DD-AA Model
Figure 16AI-2: Effects of Permanent and Temporary Increases in the Money Supply in the IS-LM Model
LM1
Expected
domestic-currency
return on
foreign-currency
deposits
Output, Y
Interest rate, R
IS2
LM2 Y1 1
IS1 1´ E1 R1 Y2 2 E2 2´ R2 Y3 3 R3 3´ E3
Exchange rate, E ( increasing)
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36. Appendix I: The IS-LM Model and the DD-AA Model
Figure 16AI-3: Effects of Permanent and Temporary Fiscal Expansions in the IS-LM Model
Output, Y
Interest rate, R LM
Expected
domestic-currency
return on
foreign-currency
deposits
IS2
IS1 2´ E2 R2 Y2 2 Yf 1 E1 1´ E3 3´ R1
Exchange rate, E ( increasing)
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37. Appendix II: Intertemporal Trade and Consumption Demand
Figure 16AII-1: Change in Output and Saving
Present
consumption
Future
Intertemporal
budget constraints 2
D2P
D2F
D1P = Q1P 1
D1F = Q1F 2´
Q2P
Indifference
curves
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38. 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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