Output and the Exchange Rate in the Short Run

Output and the Exchange Rate in the Short Run
Chapter 17 Krugman and Obstfeld 9e ECO41 International Economics Udayan Roy

Long Run and Short Run Long run theories are useful when all prices of inputs and outputs have enough time to adjust fully to changes in supply and demand. In the short run, some prices of inputs and outputs may not have time to adjust, due to labor contracts, costs of adjustment, or imperfect information about market demand. This chapter discusses a theory of the short run behavior of a “small” economy with flexible exchange rates under perfect capital mobility

Long Run and Short Run Variable Long Run Short Run
P, the overall price level Endogenous Exogenous Y, inflation-adjusted GNP Ee, expected future value of the exchange rate Every theory consist of exogenous variables and endogenous variables. Endogenous variables are those variables whose up and down movements the theory is trying to explain. Exogenous variables are those variables that the theory finds useful in explaining the up and down movements of the endogenous variables. However, the theory has nothing to say about the up and down movements of the exogenous variables. In other words, the exogenous variables are mystery variables. Changes in the exogenous variables explain changes in the endogenous variables, but the theory has no idea why the exogenous variables occasionally change in value.

Equilibrium in the markets for goods and services requires that the output of goods and services be equal to the demand for goods and services The DD curve

Determinants of Aggregate Demand
Aggregate demand (D) is the aggregate amount of goods and services that people are willing to buy. It consists of the following types of expenditure: consumption expenditure (C) investment expenditure (I) government purchases (G) net expenditure by foreigners: the current account (CA) So, aggregate demand for the domestic country’s output is 𝑫=𝑪+𝑰+𝑮+𝑪𝑨

The Four Components of Aggregate Demand
We need to specify the factors that determine C, I, G, and CA

Assumption: Consumption expenditure (C) increases when disposable income (Y − T)—which is income (Y) minus taxes (T)—increases … but by less than the increase in disposable income Real interest rates may influence the amount of saving and consumption, but we assume that they are relatively unimportant here. Wealth may also influence consumption, but we assume that it is relatively unimportant here. 𝑪= 𝑪 𝟎 + 𝑪 𝒚 ∙ 𝒀−𝑻

𝐶= 𝐶 0 + 𝐶 𝑦 ∙ 𝑌−𝑇 𝐶 𝑦 is the Marginal Propensity to Consume. It is the increase in consumption spending when after-tax income increases by one unit. Therefore, it is a positive fraction: 0 < 𝐶 𝑦 < 1 𝐶 0 is exogenous consumption. This is what consumption spending would be when after-tax income is zero. 𝐶 0 reflects the impact on consumption spending of all factors other than after-tax income. For example, 𝐶 0 may change when there are changes in interest rates, households’ wealth, or consumers’ confidence

Both investment spending (I) and government spending (G) are assumed to be exogenous Consequently, although the theory does discuss how changes in I and G affect endogenous variables such as Y and E, it has no idea what makes I and G fluctuate

Assumption: The balance on the current account (CA) increases … … when the real exchange rate (q) increases Recall that the real exchange rate is the price of foreign products relative to the price of domestic products: q = EP*/P … when disposable income decreases more disposable income (Y-T) means more expenditure on foreign products (imports). Therefore, when Y−T rises, CA falls. 𝑪𝑨= 𝑪𝑨 𝟎 + 𝑪𝑨 𝒒 ∙𝒒− 𝑪𝑨 𝒎 ∙ 𝒀−𝑻

𝐶𝐴= 𝐶𝐴 0 + 𝐶𝐴 𝑞 ∙𝑞− 𝐶𝐴 𝑚 ∙ 𝑌−𝑇 𝐶𝐴 𝑞 is the increase in the domestic country’s current account when the real exchange rate increases by one unit. Any increase (decrease) in the tariff on imported goods leads to an increase (decrease) in 𝐶𝐴 𝑞 . Note that 𝐶𝐴 𝑞 >0

𝐶𝐴= 𝐶𝐴 0 + 𝐶𝐴 𝑞 ∙𝑞− 𝐶𝐴 𝑚 ∙ 𝑌−𝑇 𝐶𝐴 𝑚 is the decrease in the domestic country’s current account (or, net exports) when after-tax income increases by one unit. When after-tax income increases by one unit, consumption spending increases by 𝐶 𝑦 units. Part of this increase in consumption is imported, and this is denoted 𝐶𝐴 𝑚 . Therefore, 0<𝐶𝐴 𝑚 < 𝐶 𝑦 , which also means 𝐶 𝑦 − 𝐶𝐴 𝑚 >0.

𝐶𝐴= 𝐶𝐴 0 + 𝐶𝐴 𝑞 ∙𝑞− 𝐶𝐴 𝑚 ∙ 𝑌−𝑇 𝐶𝐴 0 is exogenous net exports. 𝐶𝐴 0 reflects the impact on the domestic country’s current account of all factors other than the real exchange rate and after-tax income. For example, 𝐶𝐴 0 may increase when there is an increase in the foreign country’s GNP, or the domestic country increases the tariff on its imports

𝐶= 𝐶 0 + 𝐶 𝑦 ∙ 𝑌−𝑇 𝐶𝐴= 𝐶𝐴 0 + 𝐶𝐴 𝑞 ∙𝑞− 𝐶𝐴 𝑚 ∙ 𝑌−𝑇 𝐷=𝐶+𝐼+𝐺+𝐶𝐴 Therefore, 𝐷= 𝐶 0 + 𝐶 𝑦 ∙ 𝑌−𝑇 +𝐼+𝐺+ 𝐶𝐴 0 + 𝐶𝐴 𝑞 ∙𝑞− 𝐶𝐴 𝑚 ∙ 𝑌−𝑇

Short-Run Equilibrium in the Goods Market
For the goods market to be in equilibrium, GNP must equal aggregate demand: 𝒀=𝑫 Therefore, 𝐷= 𝐶 0 + 𝐶 𝑦 ∙ 𝑌−𝑇 +𝐼+𝐺+ 𝐶𝐴 0 + 𝐶𝐴 𝑞 ∙𝑞− 𝐶𝐴 𝑚 ∙ 𝑌−𝑇 becomes 𝒀= 𝑪 𝟎 + 𝑪 𝒚 ∙ 𝒀−𝑻 +𝑰+𝑮+ 𝑪𝑨 𝟎 + 𝑪𝑨 𝒒 ∙𝒒− 𝑪𝑨 𝒎 ∙ 𝒀−𝑻 This equation represents equilibrium in the domestic country’s goods markets

Note that we now have an equation in which the domestic country’s GNP (Y) and the exchange rate of the foreign country’s currency (E) are the only two endogenous variables; all other variables are exogenous. This is the DD equation.

Goods Market Equilibrium
The DD equation Note that, for specified values of all the exogenous variables in the DD equation, any increase in E must be accompanied by an increase in Y, and vice versa. That is, equilibrium in the goods market implies a direct relation between Y and E. This yields the upward-rising DD curve. The DD curve

Shifts of the DD Curve What could cause the DD curve to shift to the right? 3 DD2

Shifts of the DD Curve What could cause the DD curve to shift to the right? 3 DD2 Suppose the DD curve shifts to the right. Then, note that at any particular value of E, the value of Y indicated by the DD equation/curve must increase. For example, if E = E1 in the diagram, the equilibrium value of output indicated by the DD equation/curve must increase from Y1 to Y2. Now, what would need to happen for Y to increase when E is unchanged?

Shifts of the DD Curve So, we see that the DD curve shifts to the right if: There is an increase in C0, I, G, CA0, CAq, or P*, or There is a decrease in T or P Every one of these shifts represents an increase in aggregate demand So, the DD curve shifts right whenever an exogenous change boosts aggregate demand

Shifting the DD Curve The DD curve shifts right if: G increases
T decreases I increases P decreases P* increases C increases for some unknown reason (C0↑) CA increases for some unknown reason (CA0↑, CAq↑) Simply put, the DD curve shifts right whenever an exogenous change boosts aggregate demand

We’ve seen this before in Chapter 15
We’ve seen this before in Chapter 15. Equilibrium in the foreign currency markets requires interest rate parity. Equilibrium in the money market requires equality of money supply and money demand. The aa curve

Short Run Equilibrium for Assets
We’ve discussed two asset markets: Ch 14: Foreign exchange market interest parity: R = R* + (Ee – E)/E Ch 15: Money market money supply equals money demand in equilibrium: Ms = P × L(R, Y)

Equilibrium in Asset Markets
We simplify the money market equilibrium equation to 𝑀 𝑠 = 𝑃∙ 𝐿 0 ∙𝑌 𝑅 or equivalently to 𝑌= 𝑀 𝑠 𝐿 0 ∙𝑃 ∙𝑅 The interest parity equation then yields 𝑌= 𝑀 𝑠 𝐿 0 ∙𝑃 ∙ 𝑅 ∗ + 𝐸 𝑒 𝐸 −1 This is the AA equation, and it can be turned into the AA curve

Fig. 17-7: The AA Schedule 𝒀= 𝑴 𝒔 𝑳 𝟎 ∙𝑷 ∙ 𝑹 ∗ + 𝑬 𝒆 𝑬 −𝟏

Shifts of the AA Curve 𝑌= 𝑀 𝑠 𝐿 0 ∙𝑃 ∙ 𝑅 ∗ + 𝐸 𝑒 𝐸 −1
𝑌= 𝑀 𝑠 𝐿 0 ∙𝑃 ∙ 𝑅 ∗ + 𝐸 𝑒 𝐸 −1 Suppose the economy is initially at Point 2 Suppose there is a decrease in Ms or R* or Ee, or an increase in L0 or P If E stays unchanged at E2, then Y must decrease The economy must go from Point 2 to, perhaps, Point 3 In other words, a decrease in Ms or R* or Ee, or an increase in L0 or P shifts the AA curve left AA2 3

Shifting the AA Curve The AA curve shifts right if: Ms increases
P decreases Ee increases R* increases L decreases for some unknown reason (L0↓) Simply put, the AA curve shifts right whenever an exogenous change increases money supply or decreases money demand E 𝒀= 𝑴 𝒔 𝑳 𝟎 ∙𝑷 ∙ 𝑹 ∗ + 𝑬 𝒆 𝑬 −𝟏 E0 E1 Y Y0 Y1

Short-run macroeconomic equilibrium
All markets must be simultaneously in equilibrium Short-run macroeconomic equilibrium

Putting the Pieces Together: the DD and AA Curves
A short-run equilibrium means that there is equilibrium in all markets: the output market: aggregate demand (D) equals aggregate output (Y). the foreign exchange market: interest parity holds. the money market: money supply (MS) equals money demand (Md).

Fig. 17-8: Short-Run Equilibrium: The Intersection of DD and AA
The short run equilibrium occurs at the intersection of the DD and AA curves The output market is in equilibrium on the DD curve The asset markets are in equilibrium on the AA curve

Shifting the AA and DD Curves
The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason (C0↑) CA increases for some unknown reason (CA0↑, CAq↑) The AA curve shifts right if: Ms increases P decreases Ee increases R* increases L decreases for some unknown reason (L0↓) Knowing how some exogenous change shifts the DD and AA curves will help us predict the consequences of the exogenous change.

Short-run effects of temporary changes in …
monetary policy

Temporary Changes in Monetary Policy
Monetary policy: what central banks do to influence the economy through changes in the money supply (MS). Monetary policy primarily affects asset markets (the AA curve). 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. Specifically, temporary changes in MS do not affect Ee. Expansionary monetary policy: MS↑ Contractionary monetary policy: MS↓

The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason (C0↑) CA increases for some unknown reason (CA0↑, CAq↑) The AA curve shifts right if: Ms increases P decreases Ee increases R* increases L decreases for some unknown reason (L0↓) Knowing how some exogenous change shifts the DD and AA curves helps us predict the consequences of the exogenous change.

Temporary Changes in Monetary Policy
When there is an increase in the supply of money The AA shifts up (right) and DD is unaffected. Both E and Y increase R decreases As Ee is unaffected when the change in Ms is temporary—see next three slides—the increase in E leads to a decrease in R; recall R = R* + (Ee/E) – 1. E DD E0 AA Y Y0

Effect of Monetary Policy on q
Recall that the real exchange rate is 𝑞=𝐸∙ 𝑃 ∗ /𝑃 We just saw that when the domestic money supply increases, the foreign currency increases in value: Ms↑ implies E↑ Now, P and P* are exogenous. Although exogenous variables can change, a change in one variable cannot cause another variable that is exogenous to change.

Effect of Monetary Policy on q
Therefore, as Ms↑ implies E↑, and as P and P* are exogenous, it follows that 𝑞=𝐸∙ 𝑃 ∗ /𝑃 must also ↑

The Exchange Rate in the Future
How should we think about Ee? It is what people today expect the exchange rate to be in the future When there is a temporary change in an exogenous variable, there is no reason to expect the future value of the exchange rate to be affected Therefore, we assume that Ee is unaffected by temporary changes in the exogenous variables

But when there is a permanent change in an exogenous variable, it is reasonable to expect the future value of the exchange rate to change We saw in Ch. 16 that 𝐸= 𝑞 ∙𝑀 𝑠 ∙ 𝑅 ∗ + 𝑀 𝑠 𝑔 − 𝑌 𝑓 𝑔 − 𝜋 ∗ 𝐿 0 ∙ 𝑌 𝑓 ∙ 𝑃 ∗ in the long run So, if there are permanent changes in any of the variables on the right-hand side, we must assume that Ee would change. Right away!

To sum up, in short-run analysis of temporary changes in exogenous variables we treat Ee as an exogenous variable. Ee may change, just like any other exogenous variable may change. But changes in some other exogenous variable cannot cause Ee to change In short-run analysis of permanent changes in exogenous variables we treat Ee as an endogenous variable.

Effect of Monetary Policy on R
In Ch. 14 we saw the interest parity equation: 𝑅= 𝑅 ∗ + 𝐸 𝑒 𝐸 −1 We just saw that Ms↑ implies E↑ As R* and Ee are exogenous, a change in Ms cannot cause them to change Therefore, Ms↑ implies R↓ Expansionary monetary policy reduces interest rates

Two Ways to Analyze CA There are two ways to figure out the effect of a change in an exogenous variable on a country’s current account Method 1: 𝐶𝐴= 𝐶𝐴 0 + 𝐶𝐴 𝑞 ∙𝑞− 𝐶𝐴 𝑚 ∙ 𝑌−𝑇 We will return to Ch. 16 and use this to analyze the long-run behavior of CA.

Two Ways to Analyze CA To see Method 2, recall that 𝑌=𝐶+𝐼+𝐺+𝐶𝐴 in goods market equilibrium. So, 𝐶𝐴=𝑌−𝐶−𝐼−𝐺 Recall that 𝐶= 𝐶 0 + 𝐶 𝑦 ∙ 𝑌−𝑇 . Therefore, Method 2: 𝐶𝐴=𝑌− 𝐶 0 − 𝐶 𝑦 ∙ 𝑌−𝑇 −𝐼−𝐺= 1− 𝐶 𝑦 ∙𝑌− 𝐶 0 + 𝐶 𝑦 ∙𝑇−𝐼−𝐺 We will return to Ch. 16 and use this to analyze the long-run behavior of CA.

Effect of Monetary Policy on CA
Use Method 2: 𝐶𝐴= 1− 𝐶 𝑦 ∙𝑌− 𝐶 0 + 𝐶 𝑦 ∙𝑇−𝐼−𝐺 We have seen that an increase in Ms causes Y to increase. Therefore, CA must increase. That is, an increase in the supply of money, leads to an increase in the current account balance (or, net exports) R*↑ and Ee ↑ have the same effect, as does a fall in money demand (L0↓).

Exogenous Money Demand
Recall the AA and DD equations: AA: 𝑌= 𝑀 𝑠 𝐿 0 ∙𝑃 ∙ 𝑅 ∗ + 𝐸 𝑒 𝐸 −1 DD: It should be clear that the effects of L0↓ are the same as the effects of Ms↑ that we have just analyzed [Can you verify this?]

Summary: Short Run Predictions, Flexible Exchange Rate System
DD AA Y CA q E R Ms → + − L0 ← Here’s a very informal ‘story’ about the effects of expansionary monetary policy: if the domestic central bank prints more money, the value of the domestic currency will decrease and so the value of the foreign currency will increase (E↑). This makes foreign goods more expensive (q↑). As a result, the domestic net exports increase (CA↑). This increase in net exports boosts domestic aggregate demand, which raises output (Y↑). Also, when more money is printed, domestic interest rates fall (R↓). The exogenous variables—policy variables and ‘shocks’—are listed on the first column and the endogenous unknowns are listed on the first row. The predictions above are for temporary changes in the exogenous variables. The 2nd and 3rd columns show how the DD and AA curves are shifted by an increase in the exogenous variables.

Fig. 17-10: Effects of a Temporary Increase in the Money Supply
R*↑ and Ee↑ have the same effect on AA and DD. And so does a fall in money demand (L0↓).

Changes in Ee and R* Any increase in Ee, the expected future value of the foreign currency, or in R*, the foreign interest rate, cause the same shifts as expansionary monetary policy: the AA curve shifts rightward and the DD curve is unaffected Therefore, Y↑ and E↑. As P and P*, being exogenous, are unaffected, E↑ implies q↑

Changes in Ee and R* Recall that the money market’s equilibrium equation is 𝑀 𝑠 = 𝑃∙ 𝐿 0 ∙𝑌 𝑅 or, equivalently, 𝑅= 𝐿 0 ∙𝑃∙𝑌 𝑀 𝑠 As L0, P, and Ms, being exogenous, are unaffected by increases in Ee or R*, the fact that Y↑ implies R↑

Changes in Ee and R* Recall that 𝐶𝐴= 1− 𝐶 𝑦 ∙𝑌− 𝐶 0 + 𝐶 𝑦 ∙𝑇−𝐼−𝐺
We have just seen that Ee↑ or R*↑ causes Y↑ As I and G are exogenous and, therefore, unaffected by changes in Ee or R*, it must be that CA↑

DD AA Y CA q E R Ms → + − L0 ← Ee R* Here’s an informal ‘story’ about the effects of increases in R* and Ee: When the foreign interest rate rises and the expected future value of the foreign currency rises, keeping money in foreign banks becomes more attractive. So people sell the domestic currency and buy the foreign currency to move money abroad. So the domestic currency loses value and the foreign currency gains value (E↑). This makes foreign goods more expensive (q↑). Consequently the domestic country’s net exports increase (CA↑). This boosts domestic aggregate demand and output (Y↑). The rise in output causes money demand to rise, which means less lending. Less lending pushes up the domestic interest rate (R↑). In short, everything increases! The exogenous variables—policy variables and ‘shocks’—are listed on the first column and the endogenous unknowns are listed on the first row. The predictions above are for temporary changes in the exogenous variables. The 2nd and 3rd columns show how the DD and AA curves are shifted by an increase in the exogenous variables.

Short-run effects of temporary changes in …
Fiscal policy

Temporary Changes in Fiscal Policy
Fiscal policy is what governments do to influence the economy through changes in government spending (G) and taxes (T). Fiscal policy primarily influences the goods market (the DD curve). 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. Specifically, temporary changes in G and T do not affect Ee. Expansionary fiscal policy: G↑ and/or T↓ Contractionary fiscal policy: G↓ and/or T ↑

Temporary Changes in Fiscal Policy
An increase in government purchases or a decrease in taxes increases aggregate demand and output. The DD curve shifts right. Higher output increases money demand, and thereby increases interest rates, causing an increase in the value of the domestic currency (a fall in E).

Fig. 17-11: Effects of a Temporary Fiscal Expansion G↑ and/or T↓
C0↑, CA0↑, CAq↑, P*↑ and I↑ also shift DD to the right and leave AA unaffected. So, they too have the same effect: Y↑, E↓, and R↑.

Effect of Temporary Fiscal Stimulus
We just saw that expansionary fiscal policy—that is, G↑ and/or T↓—causes E↓ and Y↑. Therefore, Y – T↑ As P and P* are exogenous, they are unaffected by changes in G and T. Therefore, 𝑞=𝐸∙ 𝑃 ∗ /𝑃, which is the real exchange rate, must decrease: q↓ This argument also applies for C0↑, CA0↑, CAq↑ and I↑. So, they too cause q↓. [Verify]

Recall that 𝑅= 𝑅 ∗ + 𝐸 𝑒 𝐸 −1 (interest parity) We just saw that a temporary fiscal stimulus reduces E But it cannot affect R* and Ee, which are exogenous It follows that the domestic interest rate must increase: R↑ This argument also applies for C0↑, CA0↑, CAq↑, P*↑ and I↑. So, they too cause R↑. [Verify]

Recall that there are two ways of expressing the domestic country’s net exports (or, current account): Method 1: 𝐶𝐴= 𝐶𝐴 0 + 𝐶𝐴 𝑞 ∙𝑞− 𝐶𝐴 𝑚 ∙ 𝑌−𝑇 Method 2: 𝐶𝐴= 1− 𝐶 𝑦 ∙𝑌− 𝐶 0 + 𝐶 𝑦 ∙𝑇−𝐼−𝐺

We just saw that expansionary fiscal policy causes Y↑ and q↓ Using 𝐶𝐴= 𝐶𝐴 0 + 𝐶𝐴 𝑞 ∙𝑞− 𝐶𝐴 𝑚 ∙ 𝑌−𝑇 , it follows that CA↓ That is, expansionary fiscal policy reduces a country’s current account balance (also called net exports and trade surplus) This argument also applies for C0↑ and I↑. So, they too cause CA↓. [Verify]

Fig. 17-12: Maintaining Full Employment After a Temporary Fall in World Demand for Domestic Products
Temporary fall in world demand for domestic products reduces output below its normal level Temporary monetary expansion could depreciate the domestic currency Temporary fiscal policy could reverse the fall in aggregate demand and output

Fig. 17-13: Policies to Maintain Full Employment After a Money Demand Increase
Temporary monetary policy could increase money supply to match money demand Increase in money demand raises interest rates and appreciates the domestic currency Temporary fiscal policy could increase aggregate demand and output

Recall the AA and DD equations: AA: 𝑌= 𝑀 𝑠 𝐿 0 ∙𝑃 ∙ 𝑅 ∗ + 𝐸 𝑒 𝐸 −1 DD: It should be clear that the effects of C0↑, CA0↑, CAq↑, P*↑, and I↑ on Y, E, R and q are the same as the effects of G↑ that we have just analyzed [Can you verify this?]

DD AA Y CA q E R G, I, C0 → + − T ← Here’s an informal ‘story’ of the effects of expansionary fiscal policy: Fiscal stimulus raises domestic aggregate demand and output (Y↑). This raises money demand, meaning people become less willing to lend. This raises the domestic interest rate (R↑). So people sell foreign currencies and buy the domestic currency to move their wealth to domestic banks. This raises the value of the domestic currency and reduces the value of the foreign currency (E↓). This makes foreign goods cheaper (q↓). Both the rising income at home and the cheaper foreign goods reduce net exports (CA↓). The exogenous variables—policy variables and ‘shocks’—are listed on the first column and the endogenous unknowns are listed on the first row. The predictions above are for temporary changes in the exogenous variables. The 2nd and 3rd columns show how the DD and AA curves are shifted by an increase in the exogenous variables.

Change in Foreign Prices (P*)
We saw earlier that P*↑ causes the DD curve to shift right and has no effect on the AA curve Therefore, E↓ and Y↑. And, from 𝐶𝐴= 1− 𝐶 𝑦 ∙𝑌− 𝐶 0 + 𝐶 𝑦 ∙𝑇−𝐼−𝐺, it follows that CA↑ From 𝐶𝐴= 𝐶𝐴 0 + 𝐶𝐴 𝑞 ∙𝑞− 𝐶𝐴 𝑚 ∙ 𝑌−𝑇 , it then follows that q↑ [Can you verify this?]

Change in Foreign Prices (P*)
Recall that 𝑅= 𝑅 ∗ + 𝐸 𝑒 𝐸 −1 (interest parity) We just saw that a temporary increase in P* reduces E But it cannot affect R* and Ee, which are exogenous It follows that the domestic interest rate must increase: R↑

Change in Import Tariffs (CAq)
We saw earlier that CAq↑ causes the DD curve to shift right and has no effect on the AA curve Therefore, E↓ and Y↑. And, from 𝐶𝐴= 1− 𝐶 𝑦 ∙𝑌− 𝐶 0 + 𝐶 𝑦 ∙𝑇−𝐼−𝐺, it follows that CA↑ From 𝑞=𝐸∙ 𝑃 ∗ /𝑃, it then follows that q↓ [Can you verify this?]

Change in Import Tariffs (CAq)
Recall that 𝑅= 𝑅 ∗ + 𝐸 𝑒 𝐸 −1 (interest parity) We just saw that a temporary increase in P* reduces E But it cannot affect R* and Ee, which are exogenous It follows that the domestic interest rate must increase: R↑

An Increase in Foreign GNP (CA0↑)
We have seen before that CA0↑ causes Y↑, E↓, R↑, and q↓ Then, from 𝐶𝐴= 1− 𝐶 𝑦 ∙𝑌− 𝐶 0 + 𝐶 𝑦 ∙𝑇−𝐼−𝐺, it follows that CA↑

Change in Domestic Prices (P)
Recall that P↓ causes both AA and DD curves to shift rightward Therefore, it is clear that Y↑ But E could decrease, stay unchanged, or increase, as in the three diagrams below E E E DD DD DD AA AA AA Y Y Y

Change in Domestic Prices (P)
As Y↑, it follows from 𝐶𝐴= 1− 𝐶 𝑦 ∙𝑌− 𝐶 0 + 𝐶 𝑦 ∙𝑇−𝐼−𝐺 that CA↑ From 𝐶𝐴= 𝐶𝐴 0 + 𝐶𝐴 𝑞 ∙𝑞− 𝐶𝐴 𝑚 ∙ 𝑌−𝑇 , it then follows that q↑ [Can you verify this?] Finally, the interest parity equation (𝑅= 𝑅 ∗ + 𝐸 𝑒 𝐸 −1) implies that, as Ee and R* are exogenous and, therefore, unaffected by P↓, the ambiguous behavior of E implies that R too could decrease, stay unchanged, or increase

DD AA Y CA q E R Ms → + − L0 ← Ee R* G, I, C0 CA0 T P* CAq P ? The exogenous variables—policy variables and ‘shocks’—are listed on the first column and the endogenous unknowns are listed on the first row. The predictions above are for temporary changes in the exogenous variables. The 2nd and 3rd columns show how the DD and AA curves are shifted by an increase in the exogenous variables.

DD AA Y CA q E R Ms → + − L0 ← Ee R* G, I, C0 CA0 T P* CAq P ? Q: If the economy is in a recession—with falling output and rising unemployment—what kind of monetary and fiscal policy would be appropriate? A: Expansionary fiscal policy (G↑ and/or T↓) and expansionary monetary policy (Ms↑)

DD AA Y CA q E R Ms → + − L0 ← Ee R* G, I, C0 CA0 T P* CAq P ? Q: If the economy has a huge trade deficit and it has become necessary to increase net exports (CA), what kind of monetary and fiscal policy would be appropriate? A: Contractionary fiscal policy (G↓ and/or T↑) and expansionary monetary policy (Ms↑)

DD AA Y CA q E R Ms → + − L0 ← Ee R* G, I, C0 CA0 T P* CAq P ? Q: If foreign prices or foreign interest rates decrease, what kind of monetary and fiscal policy would keep output and unemployment stable in the domestic country? A: Expansionary fiscal policy (G↑ and/or T↓) and expansionary monetary policy (Ms↑)

Long-Run Behavior of CA
We need to return briefly to Chapter 16 for this Long-Run Behavior of CA

Short-run effects of permanent changes in government policy
Requires a quick detour of Chapter 16 Short-run effects of permanent changes in government policy

When there is a permanent change in an exogenous variable, it is reasonable to expect the future value of the exchange rate to change

We saw in Ch. 16 that in the long run 𝐸= 𝑞 ∙ 𝑀 𝑠 ∙ 𝑅 ∗ + 𝑀 𝑠 𝑔 − 𝑌 𝑝 𝑔 − 𝜋 ∗ 𝐿 0 ∙ 𝑌 𝑝 ∙ 𝑃 ∗ 𝑞 = 1− 𝐶 𝑦 − 𝐶𝐴 𝑚 ∙ 𝑌 𝑓 + 𝐶 𝑦 − 𝐶𝐴 𝑚 ∙𝑇− 𝐶 0 +𝐼+𝐺+ 𝐶𝐴 0 𝐶𝐴 𝑞 So, if there are permanent changes in any of the variables on the right-hand side, we must assume that Ee would change as indicated. Right away!

Fiscal Policy Note from the previous slide that a permanent increase in G and/or a permanent decrease in T will cause both q and E to decrease in the long run Therefore, we should expect Ee to decrease in the short run, in fact immediately G↑ and/or T↓ shifts the DD curve right And Ee ↓ shifts the AA curve left

Fiscal Policy in the Short Run
When expansionary fiscal policy is temporary, the DD curve shifts right and the AA curve is unaffected When expansionary fiscal policy is permanent, the DD curve shifts right and the AA curve shifts left Therefore, expansionary fiscal policy is less effective when it is permanent!!

Permanent Increase in Money Supply
The AA curve shifts right because of the increase in MS. The equilibrium moves from point 1 to point 3 in Fig In the long run, E will rise (See 3 slides back) This will have the immediate effect of raising Ee. The increase in Ee shifts the AA curve to the right again. The equilibrium moves from point 3 to point 2. Both E and Y increase more for a permanent increase in MS than for a temporary increase in MS.

Fig. 17-14: Short-Run Effects of a Permanent Increase in the Money Supply

Permanent ↑ in Ms: Overshooting?
AA1 is the initial AA curve AA2 is AA1 plus effect of Ee↑ caused by permanent ↑ in Ms. AA3 is AA2 plus effect of Ms/P↑ caused by permanent ↑ in Ms. In the long run, Ms/P returns to original level. So, the economy goes from the lower of the two green dots to a black dot in the short run, and to the higher of the two green dots in the long run. E E E DD2 DD2 DD2 DD1 DD1 DD1 AA3 AA3 AA3 AA2 AA2 AA2 AA1 AA1 AA1 Yp Y Yp Y Yp Y Overshooting Neither over nor under! Undershooting

Output and the Exchange Rate in the Short Run

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Output and the Exchange Rate in the Short Run

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