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 Changes in any above factors, shifts AD

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 spending A. 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 Imports A. 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 MP L 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

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

I. 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 Supply II. 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 supply C. 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 Y e Equilibrium price level for the economy at P e Shifts in AS or AD will change equilibrium level of output and price level

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 Account I. Exports A. Level of income in foreign countries, Y f Exports change with changes in foreign incomes Size of change determined by two factors 1. 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

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 on 1. 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

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 factors 1. Size of change in domestic income 2. Income elasticity of demand for imports

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 factors 1. Size of change in real exchange rate – smaller changes have smaller effects 2. Price elasticity of demand for imports – percent change in imports relative to percent change in real exchange rate – direct relationship

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 Economy I. Exchange Rate Appreciation Equilibrium exchange rate equates inflows and outflows of foreign exchange at XR e 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 FX e, and economy has equilibrium output of Y e

Effects on Open Economy I. Exchange Rate Appreciation A. 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 of current account deficit on real economy 1. 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

II. Exchange Rate Depreciation A. 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 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

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 XR e 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

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 between 1. Tradeable goods – products commonly sold in international markets 2. 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