ECO2008 International Economics Week 13b PDF

ECO2008 International Economics Output and the Exchange Rate in the Short Run Week 13b Brian Varian Introduction Long-run models are useful when all prices of inputs and outputs have time to adjust. In the short run, some prices of inputs and outputs may...

ECO2008 International Economics Output and the Exchange Rate in the Short Run Week 13b Brian Varian Introduction Long-run models are useful when all prices of inputs and outputs have time to adjust. 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 willingness of customers to pay at different prices. This chapter builds on the short-run and long-run models of exchange rates to explain how output is related to exchange rates in the short run. – It shows how macroeconomic policies can affect production, employment, and the current account. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Determinants of Aggregate Demand (1 of 3) Aggregate demand is the aggregate amount of goods and services that individuals and institutions are willing to buy: 1. consumption expenditure 2. investment expenditure 3. government purchases 4. net expenditure by foreigners: the current account Copyright © 2018 Pearson Education, Ltd. All rights reserved. Determinants of Aggregate Demand (2 of 3) Determinants of consumption expenditure include: – Disposable income: income from production (Y) minus taxes (T). – More disposable income means more consumption expenditure, but consumption typically increases less than the amount that disposable income increases. – Real interest rates may influence the amount of saving and spending on consumption goods, but we assume that they are relatively unimportant here. – Wealth may also influence consumption expenditure, but we assume that it is relatively unimportant here. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Determinants of Aggregate Demand (3 of 3) Determinants of the current account include: – Real exchange rate: prices of foreign products relative to the prices of domestic products, both measured in * domestic currency: EP P § As the prices of foreign products rise relative to those of domestic products, expenditure on domestic products rises, and expenditure on foreign products falls. – Disposable income: more disposable income means more expenditure on foreign products (imports). Copyright © 2018 Pearson Education, Ltd. All rights reserved. How Real Exchange Rate Changes Affect the Current Account (1 of 2) The current account measures the value of exports relative to the value of imports: CA » EX - IM. EP * – When the real exchange rate rises, the prices P of foreign products rise relative to the prices of domestic products. 1. The volume of exports that are bought by foreigners rises. 2. The volume of imports that are bought by domestic residents falls. 3. The value of imports in terms of domestic products rises: the value/price of imports rises, since foreign products are more valuable/expensive. Copyright © 2018 Pearson Education, Ltd. All rights reserved. How Real Exchange Rate Changes Affect the Current Account (2 of 2) If the volumes of imports and exports do not change much, the value effect may dominate the volume effect when the real exchange rate changes. – For example, contract obligations to buy fixed amounts of products may cause the volume effect to be small. However, evidence indicates that for most countries the volume effect dominates the value effect after one year or less. Letʼs assume for now that a real depreciation leads to an increase in the current account: the volume effect dominates the value effect. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Table 17.1 Factors Determining the Current Account Copyright © 2018 Pearson Education, Ltd. All rights reserved. Determinants of Aggregate Demand (1 of 4) Determinants of the current account include: – Real exchange rate: an increase in the real exchange rate increases the current account. – Disposable income: an increase in the disposable income decreases the current account. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Determinants of Aggregate Demand (2 of 4) For simplicity, we assume that exogenous political factors determine government purchases G and the level of taxes T. For simplicity, we currently assume that investment expenditure I is determined by exogenous business decisions. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Determinants of Aggregate Demand (3 of 4) Aggregate demand is therefore expressed as: æ EP * ö D = C (Y -T ) + I + G + CA ç ,Y -T ÷ è P ø – where C(Y − T) is consumption expenditure as a function of disposable income, – I + G is investment expenditure and government purchases (both exogenous), and æ – CA ç EP * ö ,Y -T ÷ is the current account as a function of è P ø the real exchange rate and disposable income. æ EP * ö Or more simply: D = D ç ,Y - T , I,G ÷ è P ø Copyright © 2018 Pearson Education, Ltd. All rights reserved. Determinants of Aggregate Demand (4 of 4) Determinants of aggregate demand include: – Real exchange rate: an increase in the real exchange rate increases the current account, and therefore increases aggregate demand of domestic products. – Disposable income: an increase in the disposable income increases consumption expenditure, but decreases the current account. § Since consumption expenditure is usually greater than expenditure on foreign products, the first effect dominates the second effect. § As income increases for a given level of taxes, aggregate consumption expenditure and aggregate demand increase by less than income. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 17.1 Aggregate Demand as a Function of Output EP* Aggregate demand is a function of the real exchange rate , disposable income (Y− T), P investment demand (I), and government spending (G). If all other factors remain unchanged, a rise in output (real income), Y, increases aggregate demand. Because the increase in aggregate demand is less than the increase in output, the slope of the aggregate demand function is less than 1 (as indicated by its position within the 45-degree angle). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Short-Run Equilibrium for Aggregate Demand and Output Equilibrium is achieved when the value of output and income from production Y equals the value of aggregate demand D æ EP * ö Y = Dç ,Y -T , I,G ÷ è P ø – where aggregate demand is a function of the real exchange rate, disposable income, investment expenditure and government purchases. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 17.2 The Determination of Output in the Short Run In the short run, output settles at Y 1 (point 1), where aggregate demand, D1, equals aggregate output, Y 1. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Short-Run Equilibrium and the Exchange Rate: DD Schedule (1 of 2) How does the exchange rate affect the short-run equilibrium of aggregate demand and output? With fixed domestic and foreign levels of average prices, a rise in the nominal exchange rate makes foreign goods and services more expensive relative to domestic goods and services. A rise in the nominal exchange rate (a domestic currency depreciation) increases aggregate demand of domestic products. In equilibrium, production will increase to match the higher aggregate demand. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 17.3 Output Effect of a Currency Depreciation with Fixed Output Prices A rise in the exchange rate from E 1 to E 2 (a currency depreciation) 2 raises aggregate demand to Aggregate demand (E ) and output to Y 2 , all else equal. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 17.4 Deriving the DD Schedule The DD schedule (shown in the lower panel) slopes upward because a rise in the 1 2 1 2 exchange rate from E to E all else equal, causes output to rise from Y to Y. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Short-Run Equilibrium and the Exchange Rate: DD Schedule (2 of 2) DD schedule shows combinations of output and the exchange rate at which the output market is in short-run equilibrium (such that aggregate demand = aggregate output). slopes upward because a rise in the exchange rate causes aggregate demand and aggregate output to rise. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Shifting the DD Curve (1 of 3) Changes in the exchange rate cause movements along a DD curve. Other changes cause it to shift: 1. Changes in G: more government purchases cause higher aggregate demand and output in equilibrium. Output increases for every exchange rate: the DD curve shifts right. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 17.5 Government Demand and the Position of the DD Schedule A rise in government demand from G1 to G 2 raises output at every level of the exchange rate. The change therefore shifts DD to the right. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Shifting the DD Curve (2 of 3) 2. Changes in T: lower taxes generally increase consumption expenditure, increasing aggregate demand and output in equilibrium for every exchange rate: the DD curve shifts right. 3. Changes in I: higher investment expenditure is represented by shifting the DD curve right. 4. Changes in P relative to P*: lower domestic prices relative to foreign prices are represented by shifting the DD curve right. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Shifting the DD Curve (3 of 3) 5. Changes in C: willingness to consume more and save less is represented by shifting the DD curve right. 6. Changes in demand of domestic goods relative to foreign goods: willingness to consume more domestic goods relative to foreign goods is represented by shifting the DD curve right. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Short-Run Equilibrium in Asset Markets (1 of 2) Consider two sets of asset markets: 1. Foreign exchange markets – interest parity represents equilibrium: R = R * + ( E e -E) E 2. Money market – Equilibrium occurs when the quantity of real monetary assets supplied matches the quantity of real monetary MS assets demanded: = L ( R,Y ) P – A rise in income from production causes the demand of real monetary assets to increase. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 17.6 Output and the Exchange Rate in Asset Market Equilibrium For the asset (foreign exchange and money) markets to remain in equilibrium, a rise in output must be accompanied by an appreciation of the currency, all else equal. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Short-Run Equilibrium in Asset Markets (2 of 2) When income and production increase, – demand of real monetary assets increases, – leading to an increase in domestic interest rates, – leading to an appreciation of the domestic currency. Recall that an appreciation of the domestic currency is represented by a fall in E. When income and production decrease, the domestic currency depreciates and E rises. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Short-Run Equilibrium in Asset Markets: AA Curve The inverse relationship between output and exchange rates needed to keep the foreign exchange markets and the money market in equilibrium is summarized as the AA curve. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 17.7 The AA Schedule The asset market equilibrium schedule (AA) slopes downward because a rise in output from Y 1 to Y 2 , all else equal, causes a rise in the home interest rate and a domestic currency appreciation from E 1 to E 2. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Shifting the AA Curve (1 of 3) 1. Changes in M s: an increase in the money supply reduces interest rates in the short run, causing the domestic currency to depreciate (a rise in E) for every Y: the AA curve shifts up (right). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Shifting the AA Curve (2 of 3) 2. Changes in P: An increase in the level of average domestic prices decreases the supply of real monetary assets, increasing interest rates, causing the domestic currency to appreciate (a fall in E): the AA curve shifts down (left). 3. Changes in the demand of real monetary assets: if domestic residents are willing to hold a lower amount of real money assets and more non-monetary assets, interest rates on nonmonetary assets would fall, leading to a depreciation of the domestic currency (a rise in E): the AA curve shifts up (right). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Shifting the AA Curve (3 of 3) 4. Changes in R * : An increase in the foreign interest rates makes foreign currency deposits more attractive, leading to a depreciation of the domestic currency (a rise in E): the AA curve shifts up (right). 5. Changes in E e : if market participants expect the domestic currency to depreciate in the future, foreign currency deposits become more attractive, causing the domestic currency to depreciate (a rise in E): the AA curve shifts up (right). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Putting the Pieces Together: the DD and AA Curves (1 of 2) A short-run equilibrium means a nominal exchange rate and level of output such that 1. equilibrium in the output markets holds: aggregate demand equals aggregate output. 2. equilibrium in the foreign exchange markets holds: interest parity holds. 3. equilibrium in the money market holds: the quantity of real monetary assets supplied equals the quantity of real monetary assets demanded. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Putting the Pieces Together: the DD and AA Curves (2 of 2) A short-run equilibrium occurs at the intersection of the DD and AA curves: – output markets are in equilibrium on the DD curve – asset markets are in equilibrium on the AA curve Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 17.8 Short-Run Equilibrium: The Intersection of DD and AA The short-run equilibrium of the economy occurs at point 1, where the output market (whose equilibrium points are summarized by the DD curve) and the asset market (whose equilibrium points are summarized by the AA curve) simultaneously clear. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 17.9 How the Economy Reaches Its Short-Run Equilibrium Because asset markets adjust very quickly, the exchange rate jumps immediately from point 2 to point 3 on AA. The economy then moves to point 1 along AA as output rises to meet aggregate demand. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Temporary Changes in Monetary and Fiscal Policy Monetary policy: policy in which the central bank influences the supply of monetary assets. – Monetary policy is assumed to affect asset markets first. Fiscal policy: policy in which governments (fiscal authorities) influence the amount of government purchases and taxes. – Fiscal policy is assumed to affect aggregate demand and output first. 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Temporary Changes in Monetary Policy An increase in the quantity of monetary assets supplied lowers interest rates in the short run, causing the domestic currency to depreciate (E rises). – The AA shifts up (right). – Domestic products relative to foreign products are cheaper, so that aggregate demand and output increase until a new short-run equilibrium is achieved. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 17.10 Effects of a Temporary Increase in the Money Supply By shifting AA1 upward, a temporary increase in the money supply causes a currency depreciation and a rise in output. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Temporary Changes in Fiscal Policy An increase in government purchases or a decrease in taxes increases aggregate demand and output in the short run. – The DD curve shifts right. – Higher output increases the demand for real monetary assets, § thereby increasing interest rates, § causing the domestic currency to appreciate (E falls). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 17.11 Effects of a Temporary Fiscal Expansion By shifting DD1 to the right, a temporary fiscal expansion causes a currency appreciation and a rise in output. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Summary (1 of 2) 1. Aggregate demand is influenced by disposable income and the real exchange rate. 2. The DD curve shows combinations of exchange rates and output where aggregate demand = aggregate output. 3. The AA curve shows combinations of exchange rates and output where the foreign exchange markets and money market are in equilibrium. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Summary (2 of 2) 4. In the DD-AA model, we assume that a depreciation of the domestic currency leads to an increase in the current account and aggregate demand. 5. A temporary increase in the money supply is predicted to increase output and depreciate the domestic currency. 6. A temporary increase in government purchases is predicted to increase output and appreciate the domestic currency. Copyright © 2018 Pearson Education, Ltd. All rights reserved.