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Econ 141 Fall 2013. Slide Set 8 Introduction to Output, Exchange Rates and Macroeconomic Policies The bulk of thi s material was presented on the blackboard in class so you have it your class notes. Output, Exchange Rates and Macroeconomic Policies in the Short Run.
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Econ 141 Fall 2013 Slide Set 8 Introduction to Output, Exchange Rates and Macroeconomic Policies The bulk of this material was presented on the blackboard in class so you have it your class notes.
Output, Exchange Rates and Macroeconomic Policies in the Short Run • We extend the standard short-run model (IS-LM) to the open economy. • Openness allows foreign trade, shocks and policies to influence domestic economic activity. • Policy at home affects foreign country, and openness changes the effectiveness of domestic macroeconomic policy. • An important lesson is that the effectiveness and feasibility of macroeconomic policies depends crucially on the choice of exchange rate regime.
Aggregate demand in the open economy Assumptions for the short run: • The home and foreign price levels, and are both fixed due to price stickiness. The inflation rate and expected inflation are equal to zero in the short run. • Government expenditures and taxes are exogenous and set by policymakers. • Conditions in the foreign economy are given. Foreign output and the foreign interest rate are fixed and taken as given.
Aggregate demand in the open economy • We assume that income Y is equivalent to output: that is, gross domestic product (GDP) equals gross national disposable income (GNDI). • We also assume that net factor income from abroad (NFIA) and net unilateral transfers (NUT) are zero, which implies that the current account (CA) equals the trade balance (TB).
Aggregate demand in the open economy I. Consumption • The simplest model of aggregate private consumption relates household consumption C to disposable income Yd. • This is the Keynesian consumption function. • The slope of the consumption function is called the marginal propensity to consume (MPC). We can also define the marginal propensity to save (MPS) as 1 − MPC.
Aggregate demand in the open economy II. Investment • The firm’s borrowing cost is the expected real interest rate, which equals the nominal interest rate iminus the expected rate of inflation πe: re= i− πe. • Since expected inflation is zero, the expected real interest rate equals the nominal interest rate, re= i. • Investment I is a decreasing function of the real interest rate; that is, investment falls as the real interest rate rises. • Remember that this is true only because when expected inflation is zero, the real interest rate equals the nominal interest rate.
Aggregate demand in the open economy III. Government • The government collects T taxes from private households and spends G on government consumption of goods and services. • Taxes are net taxes, inclusive of public transfers to households, such as social security, medical care, or unemployment benefit systems. • If G = T , the government has a balanced budget. If T > G, the government is running a budget surplus (of size T − G); if G > T, a budget deficit (of size G − T ). • Government purchases = Taxes =
Aggregate demand in the open economy IV. The Trade Balance • The Role of the Real Exchange Rate: When changes in the real exchange rate change spending patterns, we say that there is expenditure switching (for example, from foreign purchases to domestic purchases). • The real exchange rate q of the home country is q = EP*/P. • We expect the trade balance of the home country to rise with the home country’s real exchange rate. When the home real exchange rate depreciates, the home country’s exports should rise and its imports fall.
Aggregate demand in the open economy IV. The Trade Balance • We expect an increase in home income to be associated with an increase in home imports and a fall in the home country’s trade balance. • We expect an increase in rest of the world income to be associated with an increase in home exports and a rise in the home country’s trade balance. • The trade balance is a function of three variables:
The Real Exchange Rate and the Trade Balance: United States, 1975–2006
The Trade Balance and the Real Exchange Rate • Local currency pricing • The price of all foreign-produced goods relative to all home-produced goods (the real exchange rate) is the weighted sum of the relative prices of the two parts of the basket. Hence, we find • When d is 0, all home goods are priced in local currency and we have our basic model. A 1% rise in E causes a 1% rise in q. There is full pass-through from changes in the nominal exchange rate to changes in the real exchange rate. But as d rises, pass-through falls.
