Chapter 17 - Output and Exchange Rate in the Short Run

Chapter Output and the Exchange Rate in the Short Run

The chapter aims to complete the macroeconomic model to explain the factors influencing output, exchange rates, and inflation.
It combines asset market knowledge and long-run exchange rate behavior with a theory of how the output market adjusts to demand changes when product prices are slow to adjust.
Institutional factors, like long-term nominal contracts, can cause "sticky" output market prices.
The long-run exchange rate model shapes expectations about future exchange rates.
Output fluctuations can deviate the economy from full employment, concerning policymakers due to impacts on trade balance and the current account.
The chapter analyzes how macroeconomic policy tools affect output and the current account and maintain full employment.

Learning Goals

Explain the role of the real exchange rate in determining the aggregate demand for a country’s output.
Analyze an open economy’s short-run equilibrium as the intersection of the asset market equilibrium schedule (AA) and the output market equilibrium schedule (DD).
Understand the short-run effects of monetary and fiscal policies on the exchange rate and national output.
Describe and interpret the long-run effects of permanent macroeconomic changes.
Explain the relationship among macroeconomic policies, the current account balance, and the exchange rate.

Determinants of Aggregate Demand in an Open Economy

Aggregate demand is the total amount of goods and services demanded by households and firms worldwide.
A country’s short-run output depends on aggregate demand, while long-run output depends on the supplies of factors of production.
Output comprises consumption, investment, government purchases, and the current account.
Aggregate demand is the sum of consumption demand (C), investment demand (I), government demand (G), and net export demand (current account, CA).
The chapter focuses on the determinants of consumption demand and the current account, assuming government and investment demand are given.

Determinants of Consumption Demand

Consumption depends on disposable income, Y_d (national income less taxes, T).
Desired consumption level: C = C(Y_d).
Consumption and disposable income are positively related; consumption increases as disposable income rises.
Consumption rises less than the increase in disposable income because part of the income increase is saved.

Determinants of the Current Account

The current account balance is the demand for exports less the demand for imports.
It is determined by the real exchange rate (q) and domestic disposable income (Y_d).
Current account balance is a function of the real exchange rate and disposable income: CA = CA(EP*/P, Y_d).
E: Nominal exchange rate (price of foreign currency in terms of domestic currency).
P^*: Foreign price level.
P: Home price level.
Real exchange rate: q = EP*/P.
Example: If the European basket costs €40 (P^*), the U.S. basket costs $50 (P), and the exchange rate is $1.10 per euro (E), then the real exchange rate is
q = (1.10 \frac{$}{€}) * \frac{(40 \frac{€}{\text{European basket}})}{(50 \frac{$}{\text{U.S. basket}})} = 0.88 \frac{\text{U.S. baskets}}{\text{European basket}} .
Real exchange rate changes affect the current account by changing the prices of domestic goods and services relative to foreign ones.
Disposable income affects the current account through its effect on total consumer spending.
The current account is related to exports (EX) and imports (IM) by the identity: CA = EX - IM.

How Real Exchange Rate Changes Affect the Current Account

A rise in q (the price of the foreign basket in domestic baskets) increases the relative price of foreign output.
Foreign consumers demand more exports, raising EX and improving the current account.
Domestic consumers purchase fewer foreign products, but IM (value of imports in domestic output) can rise if the value effect dominates.
The effect of a real exchange rate change on the current account is ambiguous.
Assumption: The volume effect outweighs the value effect, so a real depreciation improves the current account, and a real appreciation worsens it.
Producers' responses are also important; currency depreciation makes domestic intermediate inputs cheaper, leading multinational firms to shift production.
For example, BMW can shift production to the U.S. if a dollar depreciation lowers production costs.

How Disposable Income Changes Affect the Current Account

A rise in disposable income increases spending on all goods, including imports, worsening the current account.
An increase in has no effect on export demand because we are holding foreign income constant and not allowing to affect it

Table 17-1 summarizes the effects of real exchange rate and disposable income changes on the current account.

Change	Effect on Current Account (CA)
Real exchange rate, EP/P increase \| CA increase \| \| \| Real exchange rate, EP/P decrease	CA decrease
Disposable income, Yd increase \| CA decrease \| \| \| Disposable income, Yd decrease	CA increase

The Equation of Aggregate Demand

Total aggregate demand: D = C + I + G + CA.
Disposable income: Y_d = Y - T.
Aggregate demand as a function: D = C(Y - T) + I + G + CA(EP*/P, Y - T).
Simplified: D = D(EP*/P, Y - T, I, G).

The Real Exchange Rate and Aggregate Demand

A rise in EP*/P (real depreciation) makes domestic goods cheaper, increasing CA and aggregate demand D.
A real depreciation raises aggregate demand; a real appreciation lowers it.

Real Income and Aggregate Demand

If taxes are fixed, a rise in represents an equal rise in disposable income
A rise in domestic real income raises consumption but worsens the current account by increasing import spending.
The effect of disposable income on total consumption is greater than its effect on import spending alone.
A rise in domestic real income raises aggregate demand for home output, and vice versa.
Aggregate demand depends on the real exchange rate (EP*/P), disposable income (Y - T), investment demand (I), and government spending (G).
As real income rises, consumption rises by a fraction of the increase in income; part of this increase goes into import spending.
Because part of any consumption goes to import, the effect of an increase in on aggregate demand is smaller than the accompanying rise in consumption, which is smaller than the increase in
The aggregate demand schedule has a slope less than 1.

How Output Is Determined in the Short Run

Output market equilibrium: Real domestic output equals aggregate demand for domestic output.
Y = D(EP*/P, Y - T, I, G). (17-1)
Aggregate supply and demand determine the short-run equilibrium output level.
The analysis applies to the short run because money prices are temporarily fixed; short-run real output changes eventually cause price level changes that move the economy to its long-run equilibrium.
In long-run equilibrium, factors of production are fully employed, real output is determined by factor supplies, and the real exchange rate equates long-run real output to aggregate demand.
The intersection of the aggregate demand schedule and the 45-degree line gives the output level Y_1 at which aggregate demand equals domestic output.
If aggregate demand is higher than output, firms increase production; if it's lower, firms cut back on production.
Output settles where it equals aggregate demand.

Output Market Equilibrium in the Short Run: The DD Schedule

The DD schedule shows the relationship between output and the exchange rate when the output market is in equilibrium.
It illustrates the effect of a currency depreciation (rise in ) on output, holding domestic and foreign price levels fixed.
A rise in makes foreign goods more expensive, shifting the aggregate demand schedule upward. Output expands as firms meet excess demand.
Any rise in the real exchange rate (due to a rise in E, P^* or a fall in P) causes an upward shift in aggregate demand and an expansion of output.
Any fall in the real exchange rate (due to a fall in E, P^* or a rise in P) causes output to contract.
Given the real exchange rate makes domestic goods and services cheaper relative to foreign goods and services increases aggregate demand, D, therefore going up
A real depreciation of the home currency raises aggregate demand for home output, other things equal; a real appreciation lowers aggregate demand for home output.

Deriving the DD Schedule

If P and P^* are fixed in the short run, a depreciation of the domestic currency is associated with a rise in domestic output, while an appreciation is associated with a fall in output.
The DD schedule shows all combinations of output and the exchange rate for which the output market is in short-run equilibrium.
Point 1 on the DD schedule gives the output level at which aggregate demand equals aggregate supply when the exchange rate is E_1.
A depreciation of the currency to E2 leads to a higher output level Y1, allowing to locate point 2 on DD.

Factors That Shift the DD Schedule

Government demand, taxes, investment, domestic and foreign price levels, domestic consumption behavior, and the foreign demand for home output affect the position of the DD schedule.

A change in G: An increase in government purchases shifts DD to the right; a decrease shifts DD to the left.
A change in T: An increase in taxes causes the aggregate demand function to shift downward, shifting the DD schedule leftward. A fall in taxes causes a rightward shift of DD.
A change in I: An increase in investment demand has the same effect as an increase in G: The aggregate demand schedule shifts upward and DD shifts to the right. A fall in investment demand shifts DD to the left.
A change in P: Given and , an increase in P makes domestic output more expensive relative to foreign output and lowers net export demand. The DD schedule shifts to the left when aggregate demand falls. A fall in P makes domestic goods cheaper and causes a rightward shift of DD.
A change in P^: Given E and P, a rise in P^ makes foreign goods and services relatively more expensive. Aggregate demand for domestic output therefore rises and DD shifts to the right. Similarly, a fall in P^* causes DD to shift to the left.
A change in the consumption function: An autonomous fall in consumption shifts DD to the left. Suppose residents of the home economy suddenly decide they want to consume more and save less at each level of disposable income: This implies a shift to the right of the DD schedule.
A demand shift between foreign and domestic goods: Suppose there is no change in the domestic consumption function but domestic and foreign residents suddenly decide to devote more of their spending to goods and services produced in the home country, The aggregate demand schedule shifts upward and DD therefore shifts to the right.

Any disturbance that raises aggregate demand for domestic output shifts the DD schedule to the right; any disturbance that lowers aggregate demand shifts the DD schedule to the left.

Asset Market Equilibrium in the Short Run: The AA Schedule

The AA schedule represents exchange rate and output combinations consistent with equilibrium in the domestic money market and the foreign exchange market.

Output, the Exchange Rate, and Asset Market Equilibrium

Interest parity condition: R = R* + (E^e - E)/E, where R is the interest rate on domestic currency deposits and R^* is the interest rate on foreign currency deposits.
Real money supply equals aggregate real money demand: M^s/P = L(R, Y).
Aggregate real money demand rises when the interest rate falls (because a fall in R makes interest-bearing nonmoney assets less attractive to hold) and when real output rises (people must carry out a greater volume of monetary transactions).
A rise in output must be accompanied by an appreciation of the currency for asset markets to remain in equilibrium.

Deriving the AA Schedule

For any output level Y1, there is a unique exchange rate E1 satisfying the interest parity condition.
A rise in Y produces an appreciation of the domestic currency, so the AA schedule has a negative slope.

Factors That Shift the AA Schedule

5 factors can cause the AA Schedule to shift: Changes in the domestic money supply (M^s); changes in the domestic price level (P); changes in the expected future exchange rate (E^e); changes in the foreign interest rate (R^*); and shifts in the aggregate real money demand schedule

A change in M^s: For a fixed level of output, an increase in M^s causes the domestic currency to depreciate in the foreign exchange market, causes AA to shift upward. Similarly, a fall in causes AA to shift downward.
A change in P: Given , an increase in P reduces the real money supply and drives the interest rate upward. Other thing (including ) equal, this rise in the interest rate causes to fall. The effect of a rise in P is therefore a downward shift of AA. A fall in P results in an upward shift of AA.
A change in E^e: A rise in E^e causes the domestic currency to depreciate, causing AA to shift upward. It shifts downward when the expected future exchange rate falls.
A change in R^: A rise in R^ raises the expected return on foreign currency deposits. A rise in R^* therefore has the same effect on AA as a rise in : It causes an upward shift. A fall in results in a downward shift of AA.
A change in real money demand: A reduction in money demand implies an inward shift of the aggregate real money demand function (L) for any fixed level of Y, and it thus results in a lower interest rate and a A reduction in money demand therefore has the same effect as an increase in the money supply, in that it shifts AA upward. The opposite disturbance of an increase would shift AA downward.

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

Short-run equilibrium occurs at the intersection of the DD and AA schedules, where both output and asset markets are in equilibrium.
Asset prices adjust quickly, while changes in production take time, so asset markets remain in continual equilibrium even while output is changing.

Temporary Changes in Monetary and Fiscal Policy

Government policies can counteract economic disturbances to maintain full employment.
The analysis concentrates on monetary policy (changes in the money supply) and fiscal policy (changes in government spending or taxes).
The economy is assumed not to influence the foreign interest rate or price level, and the domestic price level is fixed in the short run.

Monetary Policy

A temporary increase in the money supply shifts AA upward but does not affect DD, causing a currency depreciation and an output expansion.
To preserve interest parity, the exchange rate must depreciate immediately to create the expectation that the home currency will appreciate in the future at a faster rate than expected before R. This makes home products cheaper relative to foreign products causing an increase in aggregate demand.

Fiscal Policy

Expansionary fiscal policy (increase in government spending or cut in taxes) shifts the DD schedule to the right but does not move AA, causing the currency to appreciate and output to expand.

Policies to Maintain Full Employment

Temporary monetary and fiscal expansion can counteract temporary disturbances that lead to recession.
Disturbances that lead to overemployment can be offset through contractionary macroeconomic policies.
To restore full employment, the government may use monetary or fiscal policy, or both.
A temporary fiscal expansion shifts D D back to its original position, restoring full employment and returning the exchange rate to . A temporary money supply increase shifts the asset market equilibrium curve to and places the economy at point 3, a move that restores full employment but causes the home currency to depreciate even further.

Inflation Bias and Other Problems of Policy Formulation

Sticky nominal prices can tempt governments to create politically useful economic booms, leading to an inflation bias.
It can be hard to determine whether a disturbance originates in the output or asset markets.
Real-world policy choices are often determined by bureaucratic necessities rather than detailed economic considerations.
Fiscal policy's impact on the government budget can be a problem.
Policies operate with lags, and it's hard to evaluate the size and persistence of shocks.

Permanent Shifts in Monetary and Fiscal Policy

A permanent policy shift alters both the current and long-run exchange rates, affecting expectations about future exchange rates.
The economy is assumed to be initially at a long-run equilibrium position.

A Permanent Increase in the Money Supply

A permanent increase in the money supply shifts AA upward by more than a temporary increase does, causing a larger currency depreciation and output expansion in the short run.
Over time, inflationary pressure pushes the price level to its new long-run value, returning the economy to full employment.
To maintain full employment a permanent increase in money demand should be offset with a permanent increase of equal magnitude in the money supply.

A Permanent Fiscal Expansion

The additional currency appreciation reduces the policy's expansionary effect on output which can reduce aggregate demand
If the economy starts at long-run equilibrium, a permanent change in fiscal policy has no net effect on output; it causes an immediate exchange rate jump that offsets the policy’s direct effect on aggregate demand.
In fact permanent change in fiscal policy can have a null effect on output

Macroeconomic Policies and the Current Account

Point 2 lies above XX, the current account has improved as a result of the policy action. Monetary expansion causes the current account balance to increase in the short run
Temporary fiscal expansion shifts DD to the right and moves the economy to point 3 in the figure. Because the currency appreciates and income rises, there is a deterioration in the current account. A permanent fiscal expansion also shifts AA leftward, producing an equilibrium at point 4. The current account worsens.
Expansionary fiscal policy reduces the current account balance

Gradual Trade Flow Adjustment and Current Account Dynamics

The J-Curve

The J-curve effect describes a situation where a country’s current account worsens immediately after a real currency depreciation and improves only some months later.
Empirical evidence indicates for most industrial countries a J-curve lasting more than six months but less than a year.
The existence of a significant J-curve effect forces forces us to modify some of our earlier conclusions, at least for the short run of a year or less.

Exchange Rate Pass-Through and Inflation

Nominal exchange rate changes are assumed to cause proportional changes in real exchange rates in the short run.
Incomplete pass-through means that currency movements have less-than-proportional effects on the relative prices determining trade volumes. The failure of relative prices to adjust will in turn be accompanied by a slow adjustment of trade volumes.
Data for the United States support this theoretical pattern. The figure on page 451 plots data on the U.S. current account and the dollar’s real exchange rate since 1976. (In the figure, a rise in the exchange rate index is a real dollar appreciation; a decline is a real depreciation.) During the 1976–2009 period, there were two episodes of sharply increased current account deficits, both associated with fiscal expansions. The first episode occurred when President Ronald Reagan cut taxes and increased military spending shortly after he entered the White House in 1981. You can see that the dollar’s initial response was a substantial real ap- preciation. After 1985, however, the dollar began to decline sharply even though the current account deficit had not yet turned around. The declining path of U.S. relative wealth implied that the current account would eventually return closer to balance

The Liquidity Trap

A liquidity trap is a situation where nominal interest rates are near zero, and the central bank cannot lower them further by increasing the money supply.
Figure 17-19 shows how the DD-AA diagram can be modified to depict the equilibrium positions involving a liquidity trap. The DD schedule is the same, but the AA schedule now has a flat segment at levels of output so low that the money mar- ket finds its equilibrium at an interest rate equal to zero. The horizontal stretch of AA gives rise to the liquidity trap
In contrast to the case we examined earlier in this chapter, an increase in the money supply will have no effect on the economy!
A central bank that progressively reduces the money supply by selling bonds will eventually succeed in pushing the interest rate up—the economy cannot function without some money—but that possibility is not helpful when the economy is in a slump and a fall in interest rates is the medicine that it needs.

Chapter Summary

The aggregate demand for an open economy’s output consists of four components corresponding to the four components of GNP: consumption demand, investment demand, government demand, and the current account (net export demand). An important determinant of the current account is the real exchange rate, the ratio of the for- eign price level (measured in domestic currency) to the domestic price level.
Output is determined in the short run by the equality of aggregate demand and aggre- gate supply. When aggregate demand is greater than output, firms increase production to avoid unintended inventory depletion. When aggregate demand is less than output, firms cut back production to avoid unintended accumulation of inventories.
The economy’s short-run equilibrium occurs at the exchange rate and output level where—given the price level, the expected future exchange rate, and foreign economic conditions—aggregate demand equals aggregate supply and the asset markets are in equilibrium. In a diagram with the exchange rate and real output on its axes, the short- run equilibrium can be visualized as the intersection of an upward-sloping DD sched- ule, along which the output market clears, and a downward-sloping AA schedule, along which the asset markets clear.
A temporary increase in the money supply, which does not alter the long-run expected exchange rate, causes a depreciation of the currency and a rise in output. Temporary fiscal expansion also results in a rise in output, but it causes the currency to appreciate. Monetary policy and fiscal policy can be used by the government to offset the effects of disturbances to output and employment. Temporary monetary expansion is power- less to raise output or move the exchange rate, however, when the economy is in a zero-interest liquidity trap.
Permanent shifts in the money supply, which do alter the long-run expected exchange rate, cause sharper exchange rate movements and therefore have stronger short-run effects on output than transitory shifts. If the economy is at full employment, a perma- nent increase in the money supply leads to a rising price level, which ultimately reverses the effect on the real exchange rate of the nominal exchange rate’s initial de- preciation. In the long run, output returns to its initial level and all money prices rise in proportion to the increase in the money supply.
Because permanent fiscal expansion changes the long-run expected exchange rate, it causes a sharper currency appreciation than an equal temporary expansion. If the econ- omy starts out in long-run equilibrium, the additional appreciation makes domestic goods and services so expensive that the resulting “crowding out” of net export demand nullifies the policy’s effect on output and employment. In this case, a perma- nent fiscal expansion has no expansionary effect at all.
A major practical problem is ensuring that the government’s ability to stimulate the economy does not tempt it to gear policy to short-term political goals, thus creating an inflation bias. Other problems include the difficulty of identifying the sources or dura- tions of economic changes and time lags in implementing policies.
If exports and imports adjust gradually to real exchange rate changes, the current ac- count may follow a J-curve pattern after a real currency depreciation, first worsening