Lecture 4: Output Determination in an Open Economy

This is for International Economics Lecture 4 for the 2026 summer exam.

What is aggregate demand?

The total amount of goods and services that people are willing to buy, comprising consumption, investment, government purchases, and net exports (current account)

What are the four components of aggregate demand?

Consumption expenditure, investment expenditure, government purchases, and net expenditure by foreigners (current account)

What is disposable income?

Income from production (Y) minus taxes (T)

How does disposable income affect consumption?

More disposable income leads to more consumption, but consumption increases by less than the rise in disposable income

What is the real exchange rate?

The prices of foreign products relative to domestic products, both measured in domestic currency: EP*/P

What does a rise in the real exchange rate (EP*/P) do to the current account?

It increases exports volume, decreases imports volume, but raises the value of imports — the net effect depends on whether volume or value effect dominates

What is the volume effect of a currency depreciation?

Export volumes rise and import volumes fall, improving the current account

What is the value effect of a currency depreciation?

The domestic currency value of imports rises, worsening the current account

Which effect typically dominates after about one year?

The volume effect dominates the value effect, so a real depreciation improves the current account

What is the short-run equilibrium condition for output?

Y = D(EP*/P, Y - T, I, G) — output equals aggregate demand

What is the DD schedule?

The combinations of output (Y) and exchange rate (E) at which the output market is in short-run equilibrium (aggregate demand = aggregate output)

Why does the DD curve slope upward?

A rise in E (depreciation) raises aggregate demand for domestic goods, increasing equilibrium output

What shifts the DD curve to the right?

Increases in G, decreases in T, increases in I, a rise in P*, a fall in P, or an increase in domestic consumption demand

What shifts the DD curve to the left?

A rise in domestic price level P (making domestic goods more expensive) or a fall in foreign demand for domestic goods

What is the AA schedule?

The combinations of output (Y) and exchange rate (E) at which both the foreign exchange market and money market are in equilibrium

Why does the AA curve slope downward?

A rise in output increases money demand, raising the interest rate, causing the domestic currency to appreciate (E falls)

What shifts the AA curve upward (right)?

An increase in money supply, a fall in P, a decrease in money demand, a rise in R*, or a rise in expected future exchange rate Eᵉ

What shifts the AA curve downward (left)?

A decrease in money supply or a rise in domestic price level P

Where is short-run equilibrium in the DD-AA model?

At the intersection of the DD and AA curves, where both output and asset markets are simultaneously in equilibrium

Why do asset markets adjust faster than output markets?

Asset prices (exchange rates, interest rates) adjust almost instantaneously, while production changes take time

What is a temporary policy change?

A policy change expected to be reversed in the near future, so it does not affect long-run exchange rate expectations

What is the short-run effect of a temporary monetary expansion?

AA shifts up (right), the currency depreciates, aggregate demand rises, and output increases

What is the short-run effect of a temporary fiscal expansion?

DD shifts right, output rises, money demand increases, interest rates rise, and the currency appreciates (E falls)

What is a permanent policy change?

A policy change not expected to be reversed, which alters long-run exchange rate expectations

How does a permanent monetary expansion differ from a temporary one in its short-run effect?

It shifts AA further up because people also expect future depreciation, causing a larger actual depreciation and greater output increase

What happens to DD and AA in the long run after a permanent money supply increase?

Rising prices shift both DD and AA back to the left until output returns to full-employment level Yf

What does long-run neutrality of money mean?

In the long run, a permanent money supply increase raises E and P proportionally, leaving real variables (output, real exchange rate) unchanged

What is the short-run effect of a permanent fiscal expansion?

Both DD shifts right (higher aggregate demand) and AA shifts down-left (expected appreciation), leaving output unchanged at Yf if starting from long-run equilibrium

What is crowding out in the context of a permanent fiscal expansion?

The currency appreciation caused by a permanent rise in G completely offsets the boost to aggregate demand by reducing net exports

What is the XX curve?

The combinations of output and exchange rate at which the current account is held constant at its initial level

Why does the XX curve slope upward?

As income rises, imports increase and worsen the CA, so E must rise (depreciate) to keep the current account constant

Why is the XX curve flatter than the DD curve?

Along DD, E must rise more steeply to keep total aggregate demand equal to output; along XX, only the current account (not total demand) must be maintained

How does a temporary monetary expansion affect the current account?

It depreciates the currency, moving the economy above XX, improving the current account

How does a temporary fiscal expansion affect the current account?

It appreciates the currency, moving the economy below XX, worsening the current account

How does a permanent fiscal expansion affect the current account compared to a temporary one?

It worsens the current account more, because both DD and AA shift (AA also shifts due to expected appreciation)

What is the J-curve?

The pattern where a currency depreciation initially worsens the current account before improving it, as the value effect initially dominates the volume effect

Why does the current account initially worsen after a depreciation?

Import volumes are fixed by contracts in the short run, so the higher domestic currency cost of imports raises their value while export volumes don't immediately rise

What is exchange rate pass-through?

The percentage by which import prices rise when the domestic currency depreciates by 1%

What happens if pass-through is less than 100%?

Import prices don't fully adjust to the depreciation, dampening the J-curve effect and reducing the impact on the current account

How do global value chains affect the current account response to depreciation?

Backward and forward linkages (imported inputs in exports) dampen the current account effect of depreciation, but higher trade volumes may offset this, leaving the overall impact roughly unchanged