Chapter 16 Output and the Exchange Rate in the Short Run
Chapter 16 ▪ Output and the Exchange Rate in the Short Run
Chapter organization Determinants of Aggregate Demand in an Open Economy The Equation of Aggregate Demand a How Output Is determined in the Short run a Output Market Equilibrium in the Sort Run: The DD Schedule Asset Market Equilibrium in the Short Run: The AA Schedule Short-Run Equilibrium for an Open economy Putting the dd and AA Schedules Together Copyright C 2003 Pearson Education, Inc Slide 16-2
Copyright © 2003 Pearson Education, Inc. Slide 16-2 Chapter Organization ▪ Determinants of Aggregate Demand in an Open Economy ▪ The Equation of Aggregate Demand ▪ How Output Is Determined in the Short Run ▪ Output Market Equilibrium in the Sort Run: The DD Schedule ▪ Asset Market Equilibrium in the Short Run: The AA Schedule ▪ Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together
Chapter organization Temporary Changes in Monetary and Fiscal Policy a Inflation Bias and Other Problems of policy Formulation a Permanent Shifts in Monetary and Fiscal Policy Macroeconomic Policies and the current account Gradual Trade Flow Adjustment and Current Account Dynamics Summary Copyright C 2003 Pearson Education, Inc Slide 16-3
Copyright © 2003 Pearson Education, Inc. Slide 16-3 ▪ Temporary Changes in Monetary and Fiscal Policy ▪ Inflation Bias and Other Problems of Policy Formulation ▪ Permanent Shifts in Monetary and Fiscal Policy ▪ Macroeconomic Policies and the Current Account ▪ Gradual Trade Flow Adjustment and Current Account Dynamics ▪ Summary Chapter Organization
Chapter organization ppendix I: The /S-LM Model and the dD-AA Model Appendix ll: Intertemporal Trade and Consumption Demand Appendix Ill: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities Copyright C 2003 Pearson Education, Inc Slide 16-4
Copyright © 2003 Pearson Education, Inc. Slide 16-4 ▪ Appendix I: The IS-LM Model and the DD-AA Model ▪ Appendix II: Intertemporal Trade and Consumption Demand ▪ Appendix III: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities Chapter Organization
Introduction Macroeconomic changes that affect exchange rates interest rates, and price levels may also affect output This chapter introduces a new theory of how the output market adjusts to demand changes when product prices are themselves slow to adjust A short-run model of the output market in an open economy will be utilized to analyze The effects of macroeconomic policy tools on output and the current account The use of macroeconomic policy tools to maintain full employment Copyright C 2003 Pearson Education, Inc Slide 16-5
Copyright © 2003 Pearson Education, Inc. Slide 16-5 Introduction ▪ Macroeconomic changes that affect exchange rates, interest rates, and price levels may also affect output. • This chapter introduces a new theory of how the output market adjusts to demand changes when product prices are themselves slow to adjust. ▪ A short-run model of the output market in an open economy will be utilized to analyze: • The effects of macroeconomic policy tools on output and the current account • The use of macroeconomic policy tools to maintain full employment
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 a The aggregate demand for an open economy's output consists of four components Consumption demand(c) ° Investment demand( ° Government demand(G ° Current account(CA) Copyright C 2003 Pearson Education, Inc Slide 16-6
Copyright © 2003 Pearson Education, Inc. Slide 16-6 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. ▪ The aggregate demand for an open economy’s output consists of four components: • Consumption demand (C) • Investment demand (I) • Government demand (G) • Current account (CA)
Determinants of Aggregate Demand in an Open Economy Determinants of Consumption Demand Consumption demand increases as disposable income (i. e, national income less taxes) increases at the aggregate level The increase in consumption demand is less than the increase in the disposable income because part of the income increase is saved Copyright C 2003 Pearson Education, Inc Slide 16-7
Copyright © 2003 Pearson Education, Inc. Slide 16-7 ▪ Determinants of Consumption Demand • Consumption demand increases as disposable income (i.e., national income less taxes) increases at the aggregate level. – The increase in consumption demand is less than the increase in the disposable income because part of the income increase is saved. Determinants of Aggregate Demand in an Open Economy
Determinants of Aggregate Demand in an Open Economy Determinants of the current account The Ca balance is viewed as the demand for a country's exports(EX) less that country's own demand for imports(IM) The Ca balance is determined by two main factors The domestic currency's real exchange rate against foreign currency(q=EP*/P) Domestic disposable income (yo Copyright C 2003 Pearson Education, Inc Slide 16-8
Copyright © 2003 Pearson Education, Inc. Slide 16-8 ▪ Determinants of the Current Account • The CA balance is viewed as the demand for a country’s exports (EX) less that country's own demand for imports (IM). • The CA balance is determined by two main factors: – The domestic currency’s real exchange rate against foreign currency (q = EP*/P) – Domestic disposable income (Y d ) Determinants of Aggregate Demand in an Open Economy
Determinants of Aggregate Demand in an Open Economy How Real Exchange Rate Changes Affect the Current Account An increase in g raises eX and improves the domestic country's Ca Each unit of domestic output now purchases fewer units of foreign output, therefore, foreign will demand more exports An increase g can raise or lower IM and has an ambiguous effect on CA IM denotes the value of imports measured in terms of domestic output Copyright C 2003 Pearson Education, Inc Slide 16-9
Copyright © 2003 Pearson Education, Inc. Slide 16-9 ▪ How Real Exchange Rate Changes Affect the Current Account • An increase in q raises EX and improves the domestic country’s CA. – Each unit of domestic output now purchases fewer units of foreign output, therefore, foreign will demand more exports. • An increase q can raise or lower IM and has an ambiguous effect on CA. – IM denotes the value of imports measured in terms of domestic output. Determinants of Aggregate Demand in an Open Economy
Determinants of Aggregate Demand in an Open Economy There are two effects of a real exchange rate Volume effect The effect of consumer spending shifts on export and Import quantities Value effect It changes the domestic output worth of a given volume of foreign imports a Whether the Ca improves or worsens depends on which effect of a real exchange rate change is dominant We assume that the volume effect of a real exchange rate change al ways outweighs the value effect Copyright C 2003 Pearson Education, Inc Slide 16-10
Copyright © 2003 Pearson Education, Inc. Slide 16-10 ▪ There are two effects of a real exchange rate: • Volume effect – The effect of consumer spending shifts on export and import quantities • Value effect – It changes the domestic output worth of a given volume of foreign imports. ▪ Whether the CA improves or worsens depends on which effect of a real exchange rate change is dominant. ▪ We assume that the volume effect of a real exchange rate change always outweighs the value effect. Determinants of Aggregate Demand in an Open Economy
