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Chapter 16 Output and the Exchange Rate in the Short Run. Supplementary Notes. Introduction. This chapter builds on the short run and long models of exchange rates to explain how output and the exchange rate are determined in the short run.
Aggregate demand is the aggregate amount of goods and services that people are willing to buy:
Determinants of consumption expenditure include:
Determinants of the current account include:
The current account measures the value of exports less the value of imports: CA ≈ EX – IM.
Current account in domestic currency = PQx – EP*Qm
Current account in real terms = Qx – (EP*/P)Qm
EX Qx, IM (EP*/P)Qm
When the real exchange rate EP*/P rises, the prices of foreign products rise relative to the prices of domestic products.
a function of the real
exchange rate and
as a function
exogenousDeterminants of Aggregate Demand (cont.)
D = C(Y – T) + I + G + CA(EP*/P, Y – T)
D = D(EP*/P, Y – T, I, G)
Determinants of aggregate demand include:
real exchange rate, disposable income,
investment, government purchases
Value of output,
Equilibrium conditionShort Run Equilibrium for Aggregate Demand and Output
Y = D(EP*/P, Y – T, I, G)
outputShort Run Equilibrium for Aggregate Demand and Output (cont.)
Changes in the exchange rate cause movements along a DD curve. Other changes cause it to shift:
We consider two asset markets when considering asset market equilibrium:
Equilibrium output in money market.Short Run Equilibrium for Assets: AA Curve (cont.)
A short run equilibrium means the nominal exchange rate and level of output such that:
Exchange rates adjust immediately so that asset markets are in equilibrium.
The domestic currency appreciates and output increases until output markets are in equilibrium.How the Economy Reaches Equilibrium in the Short Run
Discuss the effects of each of the following shocks on output and the exchange rate using the DD-AA model (with diagram).
Temporary fall in world demand for domestic products reduces output below its normal level
Temporary fiscal policy could reverse
the fall in aggregate demand and outputPolicies to Maintain Full Employment (cont.)
decreases interest rates and causes people to expect a future depreciation, leading to a large actual depreciationEffects of Permanent Changes in Monetary Policy in the Short Run
Higher prices make domestic products more expensive relative to foreign goods: reduction in aggregate demand
Higher prices reduce
real money supply,
rates, leading to a
In the long run, output returns to its normal level, and we also see
E1 < E3 < E2Effects of Permanent Changes in Monetary Policy in the Long Run (cont.)
When the increase of government purchases is permanent, the domestic currency is expected to appreciate, and does appreciate.Effects of Permanent Changes in Fiscal Policy (cont.)
An increase in the money supply shifts up the AA curve and depreciates the domestic currency, increasing the current account above XX.
A temporary fiscal expansion shifts the DD and appreciates the domestic currency,
decreasing the CA below XX.
Because the AA curve also shifts, a permanent fiscal expansion decreases the CA more.Macroeconomic Policies and the Current Account (cont.)
effect of real
on the CA
Assume P=P*=1, R*=0. Then,