Economics Chapter: Real Exchange Rate Effects

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Questions and Answers

How does a rise in the real exchange rate affect the volume of exports?

A rise in the real exchange rate increases the volume of exports bought by foreigners.

What is the impact of a rising real exchange rate on the volume of imports purchased by domestic residents?

The volume of imports purchased by domestic residents falls when the real exchange rate rises.

In what situation may the value effect dominate the volume effect when the real exchange rate changes?

The value effect may dominate the volume effect when contract obligations limit changes in import and export volumes.

What generally happens to the current account when there is real depreciation of the currency?

Real depreciation generally leads to an increase in the current account. Signup and view all the answers

How does disposable income influence the current account?

An increase in disposable income decreases the current account. Signup and view all the answers

What are the main determinants of the current account mentioned in the content?

The main determinants of the current account are the real exchange rate and disposable income. Signup and view all the answers

What assumption is made about investment expenditure in the context provided?

It is assumed that investment expenditure is determined by exogenous business decisions. Signup and view all the answers

How do fixed product contract obligations affect the response of exports and imports to real exchange rate changes?

Fixed contract obligations may cause the volume effect to be small despite changes in the real exchange rate. Signup and view all the answers

How do long-run models differ from short-run models in terms of price adjustment?

Long-run models assume all prices of inputs and outputs have time to adjust, while short-run models acknowledge that some prices may remain fixed due to factors like labor contracts and adjustment costs. Signup and view all the answers

What are the four main components of aggregate demand?

The four main components of aggregate demand are consumption expenditure, investment expenditure, government purchases, and net expenditure by foreigners (current account). Signup and view all the answers

What impact does disposable income have on consumption expenditure?

Higher disposable income generally leads to increased consumption expenditure, although the increase in consumption is typically less than the increase in disposable income. Signup and view all the answers

How do real interest rates affect consumption expenditure in the context provided?

Real interest rates are assumed to be relatively unimportant influencers of saving and spending on consumption goods in this context. Signup and view all the answers

What effect does the real exchange rate have on the current account?

As the prices of foreign products rise relative to domestic products, expenditure on domestic products increases, while expenditure on foreign products decreases, positively affecting the current account. Signup and view all the answers

Why are wealth and real interest rates considered relatively unimportant in determining consumption expenditure?

Wealth and real interest rates are deemed less significant because other factors, particularly disposable income, have a more direct impact on consumption levels. Signup and view all the answers

In what ways do macroeconomic policies affect output and employment in the short run?

Macroeconomic policies can influence aggregate demand, which in turn affects production levels, employment rates, and the current account in the short run. Signup and view all the answers

What role does the current account play in aggregate demand?

The current account influences aggregate demand through net expenditure by foreigners, where higher imports or lower exports can decrease overall demand. Signup and view all the answers

What is the equation for aggregate demand as presented in the content?

The equation for aggregate demand is $D = C(Y - T) + I + G + CA(EP^*, Y - T)$. Signup and view all the answers

How does the real exchange rate affect aggregate demand?

An increase in the real exchange rate raises the current account, which subsequently increases aggregate demand for domestic products. Signup and view all the answers

What condition defines equilibrium in the context of aggregate demand and output?

Equilibrium is achieved when the value of output Y equals the value of aggregate demand D. Signup and view all the answers

What effect does an increase in disposable income have on consumption expenditure?

An increase in disposable income leads to a rise in consumption expenditure. Signup and view all the answers

How does an increase in the nominal exchange rate impact aggregate demand?

A rise in the nominal exchange rate makes foreign goods more expensive, increasing the aggregate demand for domestic products. Signup and view all the answers

Why does aggregate consumption expenditure increase by less than the increase in disposable income?

Aggregate consumption expenditure increases by less than disposable income due to the increasing level of income and unchanged tax levels. Signup and view all the answers

Describe the relationship between output (real income), Y, and aggregate demand.

A rise in output (real income), Y, leads to an increase in aggregate demand if all other factors remain unchanged. Signup and view all the answers

In the short run, what happens to output if aggregate demand increases due to currency depreciation?

In equilibrium, production will increase to match the higher aggregate demand. Signup and view all the answers

What does the DD schedule represent in the context of short-run equilibrium?

The DD schedule shows combinations of output and exchange rate where the output market is in short-run equilibrium. Signup and view all the answers

What does it mean when the slope of the aggregate demand function is less than 1?

When the slope of the aggregate demand function is less than 1, it indicates that the increase in aggregate demand is smaller than the increase in output. Signup and view all the answers

Identify the components that determine aggregate demand.

The components that determine aggregate demand include the real exchange rate, disposable income (Y - T), investment demand (I), and government spending (G). Signup and view all the answers

Explain why the DD schedule slopes upward.

The DD schedule slopes upward because a rise in the exchange rate causes both aggregate demand and aggregate output to rise. Signup and view all the answers

What does a rise in the exchange rate from E1 to E2 signify for output levels?

A rise in the exchange rate from E1 to E2 signifies an increase in output from Y1 to Y2. Signup and view all the answers

How do consumption expenditure and expenditure on foreign products relate as income increases?

As income increases, consumption expenditure usually grows larger than expenditure on foreign products, leading to a net increase in aggregate demand. Signup and view all the answers

What role does disposable income play in the aggregate demand function?

Disposable income influences aggregate demand as consumers' purchasing power affects their consumption choices. Signup and view all the answers

Why is a currency depreciation significant for domestic producers?

Currency depreciation is significant for domestic producers as it increases the competitiveness of their products relative to foreign goods. Signup and view all the answers

How does an increase in government purchases affect the DD curve?

An increase in government purchases shifts the DD curve to the right. Signup and view all the answers

What impact do lower taxes generally have on the DD curve?

Lower taxes shift the DD curve to the right. Signup and view all the answers

What does a rise in investment expenditure signify for the DD curve?

A rise in investment expenditure shifts the DD curve to the right. Signup and view all the answers

How does a reduction in domestic prices relative to foreign prices affect the DD curve?

A reduction in domestic prices relative to foreign prices shifts the DD curve to the right. Signup and view all the answers

What does an increase in consumer willingness to spend imply for the DD curve?

An increase in consumer willingness to spend shifts the DD curve to the right. Signup and view all the answers

How does a change in the demand for domestic goods compared to foreign goods affect the DD curve?

An increase in the demand for domestic goods relative to foreign goods shifts the DD curve to the right. Signup and view all the answers

In asset markets, what condition describes equilibrium in the foreign exchange market?

Equilibrium in the foreign exchange market occurs when interest parity is met: $R = R^* + \frac{(E^e - E)}{E}$. Signup and view all the answers

What must accompany a rise in output for asset markets to maintain equilibrium?

An appreciation of the currency must accompany a rise in output. Signup and view all the answers

How does an increase in the money supply affect interest rates and currency valuation in the short run?

An increase in the money supply lowers interest rates and causes the domestic currency to depreciate. Signup and view all the answers

What is the result of a temporary increase in government purchases on aggregate demand and currency value?

It increases aggregate demand and results in the appreciation of the domestic currency. Signup and view all the answers

Explain how the AA and DD curves illustrate equilibrium in the context of monetary and fiscal policies.

The AA curve shows combinations of exchange rates and output where the foreign exchange and money markets are in equilibrium, while the DD curve shows combinations where aggregate demand equals aggregate output. Signup and view all the answers

What effect does a depreciation of the domestic currency have on the current account?

A depreciation of the domestic currency leads to an increase in the current account. Signup and view all the answers

Describe the relationship between disposable income, the real exchange rate, and aggregate demand.

Aggregate demand is influenced by both disposable income and the real exchange rate, with higher disposable income and favorable exchange rates increasing demand. Signup and view all the answers

What happens to output and interest rates during a temporary fiscal expansion?

Output increases while interest rates rise due to higher demand for real monetary assets. Signup and view all the answers

How is the equilibrium achieved after a temporary increase in money supply?

Equilibrium is achieved as output increases and the AA curve shifts upward, eventually stabilizing the economy. Signup and view all the answers

Summarize the effects of a temporary change in monetary policy on the economy.

A temporary increase in money supply results in a currency depreciation and an increase in output. Signup and view all the answers

Study Notes

Introduction

Long-run models are useful when all input and output prices have time to adjust
In the short run, some prices do not adjust due to factors like labor contracts, adjustment costs, or imperfect information about customer willingness to pay.
This chapter uses short-run and long-run exchange rate models to explain the relationship between output and exchange rates.
It shows how macroeconomic policies influence production, employment, and the current account.

Determinants of Aggregate Demand

Aggregate demand is the total amount of goods and services individuals and institutions are willing to buy.
Components of aggregate demand include:
- Consumption expenditure
- Investment expenditure
- Government purchases
- Net expenditure by foreigners (current account).

Determinants of Consumption Expenditure

Disposable income (income minus taxes) is a key determinant.
Increases in disposable income generally lead to increased consumption expenditure, but the percentage increase usually isn't as large as the income increase.
Real interest rates and wealth also influence consumption, but are often considered less important in short-run models.

Determinants of the Current Account

Real exchange rate (relative prices of domestic and foreign products) significantly influences the current account.
Higher foreign product prices relative to domestic products lead to less expenditure on foreign products and more on domestic products.
Higher disposable income means more expenditure on foreign products (imports).

How Real Exchange Rate Changes Affect the Current Account

The current account measures the value of exports relative to imports (CA ~ EX – IM).
When the real exchange rate rises (foreign products become more expensive relative to domestic products):
- The value of exports rises.
- The value of imports falls.
- The value of imports in terms of domestic products increases.

How Real Exchange Rate Changes Affect the Current Account (Continued)

If volumes of imports and exports do not change much, the value effect (impact on prices) might dominate the volume effect (impact on quantities) when the real exchange rate changes.
For example, fixed-amount contract obligations might limit the volume effect.
However, the volume effect usually dominates the value effect within a year or less.

Factors Determining the Current Account (Table 17.1)

Change	Effect on Current Account, CA
Real exchange rate, EP*/P ↑	CA ↑
Real exchange rate, EP*/P ↓	CA ↓
Disposable income, Yd ↑	CA ↓
Disposable income, Yd ↓	CA ↑

Determinants of Aggregate Demand (Cont.)

Determinants of the current account include the real exchange rate and disposable income. An increase in the real exchange rate increases the current account, while an increase in disposable income decreases the current account.

Determinants of Aggregate Demand (Continued 2/4)

For simplicity, political factors determining government purchases (G) and taxes (T) are considered exogenous.
Investment expenditure(I) is determined by exogenous business decisions.

Determinants of Aggregate Demand (Continued 3/4)

Aggregate demand (D) is expressed as D = C(Y-T) + I + G + CA(EP*/P, Y-T) where:
- C(Y-T) is consumption as a function of disposable income,
- I + G is investment plus government spending (exogenous),
- CA(EP*/P, Y-T) is the current account as a function of the real exchange rate and disposable income.

Determinants of Aggregate Demand (Continued 4/4)

Aggregate demand determinants include:
- Real exchange rate: an increase in the real exchange rate increases the current account and aggregate demand.
- Disposable income: an increase in disposable income increases consumption but decreases the current account. Consumption expenditure usually exceeds spending on foreign products, so the increase in aggregate demand dominates the decrease in the current account.
- As income increases for a given tax level, aggregate consumption expenditure and aggregate demand increase by less than an equal increase in income.

Short-Run Equilibrium for Aggregate Demand and Output

Equilibrium occurs when output and income equal aggregate demand (Y = D).
Aggregate demand is a function of the real exchange rate (EP*/P), disposable income (Y-T), investment (I), and government purchases (G).

Short-Run Equilibrium and the Exchange Rate (DD Schedule) 1/2

How exchange rates affect short-run equilibrium:
With fixed domestic and foreign price levels, a rise in the nominal exchange rate (domestic currency depreciation) makes foreign goods more expensive compared to domestic goods, increasing aggregate demand for domestic products.

Short-Run Equilibrium and the Exchange Rate (DD Schedule) 2/2

Production will increase to meet increased aggregate demand.
The DD schedule shows output/exchange rate combinations where the output market is in short-run equilibrium.
It slopes upward because higher exchange rates result in higher aggregate demand and output.

Shifting the DD Curve

Changes in the exchange rate cause movements along the DD curve; other changes shift it.
Changes in government purchases (G): More government purchases increase aggregate demand and output at every exchange rate, shifting the DD curve to the right.
Changes in taxes (T): Lower taxes increase consumption, increasing aggregate demand and shifting the DD curve to the right.

Shifting the DD Curve (Continued)

Changes in investment (I): Higher investment increases aggregate demand, shifting the DD curve to the right.
Changes in domestic prices relative to foreign prices (P/P*): Lower domestic prices relative to foreign prices increase aggregate demand, shifting the DD curve to the right.
Changes in consumption (C): Increased consumption willingness (less saving) shifts the DD curve to the right.
Changes in demand for domestic goods compared to foreign goods: Increased preference for domestic goods shifts the DD curve to the right.

Short-Run Equilibrium in Asset Markets (1/2)

Two sets of asset markets are considered:
- Foreign exchange markets
- Money markets
Interest parity represents equilibrium in foreign exchange markets: R = R* + (E°-E)/E; where R is the interest rate and R* is the foreign interest rate.
In the money market, equilibrium occurs when the supply of real monetary assets (M³/P) equals the demand for real monetary assets (L(R,Y)). Higher output (Y) increases demand for real monetary assets.

Short-Run Equilibrium in Asset Markets (2/2)

When income and production increase, the demand for real monetary assets also increases, leading to higher domestic interest rates.
Higher domestic interest rates cause an appreciation of the domestic currency (a fall in E).
Conversely, a decrease in income/production causes domestic currency depreciation (a rise in E).

Short-Run Equilibrium in Asset Markets: AA Curve

The inverse relationship between output and exchange rates needed to keep foreign exchange and money markets in equilibrium is summarized by the AA curve.

Shifting the AA Curve 1/3

Changes in Money Supply (M³):
- An increase in the money supply reduces interest rates, leading to domestic currency depreciation (E rises), and shifting the AA curve up (right).

Shifting the AA Curve 2/3

Changes in Domestic Prices (P):
- An increase in domestic prices increases interest rates, causing the domestic currency to appreciate (E falls), and shifting the AA curve down (left).

Shifting the AA Curve 3/3

Changes in Demand for Real Monetary Assets:
- If demand for real monetary assets decreases (e.g., preference for non-monetary assets), interest rates fall, causing domestic currency depreciation (E rises) and shifting the AA curve up (right).
Changes in Foreign Interest Rates (R*):
- Increased foreign interest rates make foreign assets more attractive and cause the domestic currency to depreciate (E rises), shifting the AA curve up.
Expected Future Exchange Rate (E°):
- Expectation of future depreciation increases supply of foreign currency causing domestic currency depreciation (E rises), and shifting the AA curve up (right).

Putting the Pieces Together: The DD and AA Curves (1/2)

Defining short-run equilibrium based on conditions in output, foreign exchange, and money markets.
Aggregate demand equals aggregate output in output markets, interest parity holds in foreign exchange markets, and supply of real monetary assets equals demand in money markets.

Putting the Pieces Together: The DD and AA Curves (2/2)

Short-run equilibrium happens where the DD and AA curves intersect.
At this point, output markets and asset markets are simultaneously in equilibrium. Output meets aggregate demand, interest parity holds to balance exchange rates, and the money market simultaneously clears with money supply/demand equal.

Temporary Changes in Monetary and Fiscal Policy

Monetary policy: Central bank influencing the money supply; affects asset markets first.
Fiscal policy: Governments influencing spending (G) and taxation (T); affects aggregate demand and output first.
Temporary changes are expected to reverse, so they won't impact long-run expectations about exchange rates.

Temporary Changes in Monetary Policy

Increasing money supply lowers interest rates.
This causes domestic currency depreciation (E rises).
The AA curve shifts up (right).
The effect is higher aggregate demand and output until a new equilibrium is reached.

Temporary Changes in Fiscal Policy

Increases in government expenditure (G) or decreases in taxes (T) increase aggregate demand.
The DD curve shifts to the right.
Higher output increases demand for real money assets, raising interest rates, causing currency appreciation, and shifting the AA curve down.

Summary 1/2

Aggregate demand is influenced by disposable income and the real exchange rate.
The DD curve shows combinations of exchange rates and output where aggregate demand meets aggregate output.
The AA curve shows combinations of exchange rates and output where foreign exchange and money markets are in equilibrium.

Summary 2/2

In the DD-AA model, domestic currency depreciation raises the current account and aggregate demand.
A temporary increase in the money supply predicts increased output and domestic currency depreciation.
A temporary increase in government purchases predicts increased output and domestic currency appreciation.

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This quiz explores the impact of real exchange rate fluctuations on the volume of exports and imports, as well as the current account. It delves into concepts like disposable income, aggregate demand components, and the relationship between real interest rates and consumption. Test your understanding of these important economic principles.