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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. D = C + I + G + CA Consumption demand C = C(Y d )

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determinants of aggregate demand in an open economy
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.

D = C + I + G + CA

    • Consumption demand C = C(Yd)
      • The increase in consumption demand is less than the increase in the disposable income because part of the income increase is saved.
    • Investment demand I
    • Government demand G
    • Current account CA = EX – IM = CA(EP*/P,Yd)
determinants of aggregate demand in an open economy1
Determinants of Aggregate Demand in an Open Economy
  • Real Exchange Rate q = EP*/P
    • Increase in q  real depreciation increase in EX
      • Each unit of domestic output purchases fewer units of foreign output  foreigners get a better deal on our output  foreigners buy more of our exports  volume of EX up
    • Increase in q can raise or lowerIM and has an ambiguous effect on CA.

Volume effect: we buy fewer imports when q increases

Value effect: we pay more in real terms (in units of domestic product) for the imports we do buy when q increases

We assume that the volume effect of a real exchange rate change outweighs the value effect: q up  CA “improves”.

determinants of aggregate demand in an open economy2
Determinants of Aggregate Demand in an Open Economy

Factors Determining the Current Account

the equation of aggregate demand

Aggregate

demand, D

Aggregate demand function,

D(EP*/P, Y – T, I, G)

45°

Output (real income), Y

The Equation of Aggregate Demand

Aggregate Demand as a Function of Output

slide5

Aggregate

demand, D

Aggregate demand =

aggregate output, D = Y

Aggregate demand

3

1

D1

2

45°

Y2

Y1

Output, Y

Y3

Output market equilibrium in the short-run: The Keynesian Cross. Real output, Y, equals aggregate demand for domestic output:Y = D(EP*/P, Y – T, I, G)

output market equilibrium in the short run the dd schedule
Output Market Equilibrium in the Short Run: The DD Schedule

Output, the Exchange Rate, and Output Market Equilibrium

  • With P and P* fixed, depreciation makes foreign goods and services more expensive relative to domestic goods and services.
    • q up (real depreciation) upward shift in aggregate demand (D) expansion of output (Y).
    • q down  downward shift in D  Y down
output market equilibrium in the short run the dd schedule1

Aggregate

demand, D

D = Y

Currency

depreciates

Aggregate demand (E2)

2

Aggregate demand (E1)

1

45°

Y1

Output, Y

Y2

Output Market Equilibrium in the Short Run: The DD Schedule

Output Effect of a Currency Depreciation with Fixed Output Prices

slide8

Aggregate demand, D

D = Y

Aggregate demand (E2)

Aggregate demand (E1)

Y1

Y2

Output, Y

Exchange rate, E

DD

E2

2

E1

1

Output, Y

Y1

Y2

The DD Schedule: combinations of output and the exchange rate where output market is in short-run equilibrium (Y = D). DD slopes upward -- a rise in the exchange rate (depreciation) Y increases.

output market equilibrium in the short run the dd schedule2
Output Market Equilibrium in the Short Run: The DD Schedule
  • Factors that Shift the DD Schedule. Increases in
    • Government purchases  expansion  DD shifts out
    • Taxes  contraction  DD shifts in
    • Investment  expansion  DD shifts out
    • Domestic price levels contraction in CA DD shifts in
    • Foreign price levels  expansion in CA  DD shifts out
    • Domestic consumption  expansion  DD shifts out
    • Demand shift between foreign and domestic goods
  • A disturbance that raises (lowers) aggregate demand for domestic output shifts the DD schedule to the right (left).
output market equilibrium in the short run the dd schedule3

Aggregate demand, D

D = Y

Government

spending rises

D(E0P*/P, Y – T, I, G2)

D(E0P*/P, Y – T, I, G1)

Y1

Y2

Output, Y

Exchange rate, E

DD1

DD2

1

2

E0

Output, Y

Y1

Y2

Output Market Equilibrium in the Short Run: The DD Schedule

Government Demand and the Position of the DD Schedule

Aggregate demand curves

slide11

AA Schedule: combinations of exchange rate and output that are consistent with asset market equilibrium (the domestic money market and the foreign exchange market).

Foreign exchange market equilibrium (interest rate parity):

R = R* + (Ee – E)/E

where: Ee is the expected future exchange rate

R is the interest rate on domestic currency deposits

R* is the interest rate on foreign currency deposits

Money Market equilibrium

Ms/P = L(R, Y)

slide12

Exchange Rate, E

Foreign

exchange

market

2'

E2

Domestic interest

rate, R

0

R2

MS

P

Money

market

Output rises

Real money

supply

1

Real domestic money holdings

Asset Market Equilibrium in the Short Run: The AA Schedule

Output and the Exchange Rate in Asset Market Equilibrium:

Y up  Ld up  R up  E down (currency appreciates)

1'

E1

Domestic-currency

return on foreign-

currency deposits

R1

L(R, Y1)

L(R, Y2)

2

slide13

Exchange

Rate, E

1

E1

2

E2

AA

Y1

Output, Y

Y2

Asset Market Equilibrium in the Short Run: The AA Schedule

The AA Schedule: Y up  E down (currency appreciation)

slide14

Asset Market Equilibrium in the Short Run: The AA Schedule

Factors that Shift the AA Schedule

  • For given Y

Domestic money supply: Ms up  R down  E up

Domestic price level: P up  Ms/P down  R up  E down

Expected future exchange rate: Ee up  E up

Foreign interest rate: R* up  E up (depreciation)

Real money demand: Ld up  R up  E down (appreciation)

short run equilibrium for an open economy putting the dd and aa schedules together

Exchange

Rate, E

DD

1

E1

AA

Y1

Output, Y

Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together

Short-Run Equilibrium: The Intersection of DD and AA

short run equilibrium for an open economy putting the dd and aa schedules together1

Exchange

Rate, E

DD

E2

2

E3

3

1

E1

AA

Y1

Output, Y

Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together

How the Economy Reaches Its Short-Run Equilibrium: asset markets clear instantly  always on AA curve

$ cheap at 2  Expected $ appreciation  rush to US assets  $ appreciation NOW

temporary changes in monetary and fiscal policy
Temporary Changes in Monetary and Fiscal Policy
  • Two types of government policy:
    • Monetary policy: works through changes in money supply.
    • Fiscal policy: works through changes in government spending (G) or taxes (T).
      • Temporary policy shifts are those that the public expects to be reversed in the near future and do not affect the long-run expected exchange rate.
      • Also, assume policy shifts do not influence the foreign interest rate and the foreign price level.
temporary change in monetary policy

Exchange

Rate, E

DD

2

E2

1

E1

AA2

AA1

Y1

Y2

Output, Y

Temporary Change in Monetary Policy

Temporary Increase in the Money Supply: R down  E up (depreciation) at each value of Y  AA shifts up

temporary change in fiscal policy

Exchange

Rate, E

DD1

DD2

1

E1

2

E2

AA

Y1

Output, Y

Y2

Temporary Change in Fiscal Policy

Temporary Fiscal Expansion: G up  Y increases at each value of E  DD shifts outward

temporary changes in monetary and fiscal policy1

Exchange

Rate, E

DD2

DD1

E3

3

2

E2

AA2

1

E1

AA1

Y2

Output, Y

Yf

Temporary Changes in Monetary and Fiscal Policy

Maintaining Full Employment After a Temporary Fall in World Demand for Domestic Products: Prop up demand with fiscal or monetary stimulus (M up  AA shifts up; G up  DD shifts out)

temporary changes in monetary and fiscal policy2

Exchange

Rate, E

DD1

DD2

E1

1

2

E2

AA1

3

E3

AA2

Y2

Output, Y

Yf

Temporary Changes in Monetary and Fiscal Policy

Policies to Maintain Full Employment After Money-Demand Up (Money “shortage”  recession). So Increase G or Ms

problems of policy formulation
Problems of Policy Formulation
  • Inflation bias
    • High inflation with no average gain in output that results from governments’ policies to prevent recession
  • Identifying the sources of economic changes
  • Identifying the durations of economic changes
  • The impact of fiscal policy on the government budget
  • Time lags in implementing policies
  • Policy impacts on current account balance
permanent shifts in monetary and fiscal policy
Permanent Shifts in Monetary and Fiscal Policy
  • A permanent policy shift affects not only the current value of the government’s policy instrument but also the long-run exchange rate.
    • This affects expectations about future exchange rates.
  • A Permanent Increase in the Money Supply
    • expected future exchange rate (Ee)rises proportionally  upward shift in AA schedule is greater than that caused by an equal, but transitory, increase
      • need expected appreciation in the future to offset lower interest rate, R
      • OVERSHOOTING
permanent shifts in monetary and fiscal policy1

Exchange

Rate, E

DD1

2

E2

3

1

E1

AA2

AA1

Yf

Y2

Output, Y

Permanent Shifts in Monetary and Fiscal Policy

Short-Run Effects of a Permanent Increase in the Money Supply (E3 is newly expected long-run exchange rate)

permanent shifts in monetary and fiscal policy2

Exchange

Rate, E

DD2

DD1

2

E2

3

E3

1

AA2

E1

AA3

AA1

Yf

Output, Y

Y2

Permanent Shifts in Monetary and Fiscal Policy

Long-Run Adjustment to a Permanent Increase in Money Supply

(As P rises, CA worsens (DD in) and R rises (AA down)

permanent fiscal expansion

Exchange

Rate, E

DD1

DD2

E1

1

3

AA1

2

E2

AA2

Output, Y

Yf

Permanent Fiscal Expansion
  • Expected Appreciation Shifts AA Down Immediately
  • No Change in Output, Even in Short-Run
  • Complete Crowding Out
macroeconomic policies and the current account
Macroeconomic Policies and the Current Account
  • XX schedule shows combinations of the exchange rate and output at which the CA balance stays at some desired level.
    • XX slopes upward: Y up  Im up  CA worsens unless currency depreciates.
      • E must increase to keep CA where it was when Y up.
    • XX is flatter than DD:
      • When currency depreciates (E up), CA improves along DD – that’s why Y increases when currency depreciates.
      • To keep CA from changing, E need only increase enough to offset increased imports attributable to output expansion.
slide28

Exchange

Rate, E

DD

2

1

E1

3

4

AA

Yf

Output, Y

Monetary Expansion AA shifts up  Depreciation  CA “improves” (Point 2)Fiscal Expansion  DD shifts out  Appreciation  CA “worsens” (Point 3 for temporary fiscal expansion; Point 4 for permanent fiscal expansion).

XX

gradual trade flow adjustment and current account dynamics
Gradual Trade Flow Adjustment and Current Account Dynamics
  • The J-Curve: if imports and exports adjust gradually to real exchange rate changes, the CA may follow a J-curve pattern after a real currency depreciation, first worsening and then improving.
      • Currency depreciation may have a contractionary initial effect on output
      • exchange rate overshooting will be amplified.
    • The J-Curve describes the time lag with which a real currency depreciation improves the CA.
gradual trade flow adjustment and current account dynamics1

Current account (in

domestic output units)

Long-run

effect of real

depreciation

on the current

account

3

1

2

Time

Real depreciation takes place and J-curve begins

End of J-curve

Gradual Trade Flow Adjustment and Current Account Dynamics

The J-Curve

gradual trade flow adjustment and current account dynamics2
Gradual Trade Flow Adjustment and Current Account Dynamics
  • Exchange Rate Pass-Through and Inflation
    • The CA in the DD-AA model has assumed that nominal exchange rate changes cause proportional changes in the real exchange rates in the short run.
    • Degree of Pass-through
      • It is the percentage by which import prices rise when the home currency depreciates by 1%.
        • In the DD-AA model, the degree of pass-through is 1.
      • Exchange rate pass-through can be incomplete because of international market segmentation.
        • Currency movements have less-than-proportional effects on the relative prices determining trade volumes.
summary
Summary
  • The aggregate demand for an open economy’s output consists of four components: consumption demand, investment demand, government demand, and the current account.
  • Output is determined in the short run by the equality of aggregate demand and aggregate supply.
  • The economy’s short-run equilibrium occurs at the exchange rate and output level.
summary1
Summary
  • A temporary increase in the money supply causes a depreciation of the currency and a rise in output.
  • Permanent shifts in the money supply cause sharper exchange rate movements and therefore have stronger short-run effects on output than transitory shifts.
  • If exports and imports adjust gradually to real exchange rate changes, the current account may follow a J-curve pattern after a real currency depreciation, first worsening and then improving.
appendix i the is lm model and the dd aa model

Interest

rate, R

LM

1

R1

IS

Y1

Output, Y

Appendix I: The IS-LM Model and the DD-AA Model

Figure 16AI-1: Short-Run Equilibrium in the IS-LM Model

slide35

Interest rate, R

LM1

LM2

1

R1

2

R2

3

R3

IS2

IS1

E2

E3

E1

Y1

Y2

Y3

Output, Y

Appendix I: The IS-LM Model

and the DD-AA Model

Figure 16AI-2: Effects of Permanent and Temporary Increases in the Money Supply in the IS-LM Model

Expected

domestic-currency

return on

foreign-currency

deposits

Exchange rate, E ( increasing)

slide36

Interest rate, R

LM

R2

2

1

R1

IS2

IS1

E1

E2

E3

Y2

Yf

Output, Y

Appendix I: The IS-LM Model and the DD-AA Model

Figure 16AI-3: Effects of Permanent and Temporary Fiscal Expansions in the IS-LM Model

Expected

domestic-currency

return on

foreign-currency

deposits

Exchange rate, E ( increasing)

slide37

Appendix II: Intertemporal Trade and Consumption Demand

Future

consumption

Intertemporal

budget constraints

Intertemporal

budget constraints

2

D2F

1

D1F = Q1F

Indifference

curves

Present

consumption

D1P = Q1P

Q2P

D2P

Figure 16AII-1: Change in Output and Saving

slide38

Appendix III: The Marshall-Lerner Condition

and Empirical Estimates of Trade Elasticities

Table 16AIII-1: Estimated Price Elasticities for International Trade

in Manufactured Goods