Output and the Exchange Rate in
the Short Run
Chapter 17 Krugman and Obstfeld 9e
ECO41 International Economics
Udayan Roy
Long Run and Short Run
• Long run theories are useful when all prices of inputs
and outputs have enough time to adjust fully to
changes in supply and demand.
• In the short run, some prices of inputs and outputs
may not have time to adjust, due to labor contracts,
costs of adjustment, or imperfect information about
market demand.
• This chapter discusses a theory of the short run
behavior of a “small” economy with flexible exchange
rates under perfect capital mobility
16-2
Long Run and Short Run
Variable
Long Run
Short Run
P, the overall price level
Endogenous
Exogenous
Y, inflation-adjusted GNP
Exogenous
Endogenous
Ee, expected future value of the exchange rate
Endogenous
Exogenous
Every theory consist of exogenous variables and endogenous variables.
Endogenous variables are those variables whose up and down movements the theory is
trying to explain.
Exogenous variables are those variables that the theory finds useful in explaining the up
and down movements of the endogenous variables. However, the theory has nothing to
say about the up and down movements of the exogenous variables. In other words, the
exogenous variables are mystery variables. Changes in the exogenous variables explain
changes in the endogenous variables, but the theory has no idea why the exogenous
variables occasionally change in value.
Equilibrium in the markets for goods and services requires that the
output of goods and services be equal to the demand for goods and
services
THE DD CURVE
Determinants of Aggregate Demand
•
•
Aggregate demand (D) is the aggregate amount of
goods and services that people are willing to buy.
It consists of the following types of expenditure:
1.
2.
3.
4.
•
consumption expenditure (C)
investment expenditure (I)
government purchases (G)
net expenditure by foreigners: the current account (CA)
So, aggregate demand for the domestic country’s
output is 𝑫 = 𝑪 + 𝑰 + 𝑮 + 𝑪𝑨
16-5
The Four Components of Aggregate
Demand
• We need to specify the factors that determine
C, I, G, and CA
Determinants of Aggregate Demand
• Assumption: Consumption expenditure (C) increases when
disposable income (Y − T)—which is income (Y) minus taxes
(T)—increases
– … but by less than the increase in disposable income
– Real interest rates may influence the amount of saving and
consumption, but we assume that they are relatively
unimportant here.
– Wealth may also influence consumption, but we assume that it
is relatively unimportant here.
• 𝑪 = 𝑪𝟎 + 𝑪𝒚 ∙ 𝒀 − 𝑻
16-7
Determinants of Aggregate Demand
• 𝐶 = 𝐶0 + 𝐶𝑦 ∙ 𝑌 − 𝑇
– 𝐶𝑦 is the Marginal Propensity to Consume. It is the
increase in consumption spending when after-tax income
increases by one unit. Therefore, it is a positive fraction: 0
< 𝐶𝑦 < 1
– 𝐶0 is exogenous consumption. This is what consumption
spending would be when after-tax income is zero. 𝐶0
reflects the impact on consumption spending of all factors
other than after-tax income. For example, 𝐶0 may change
when there are changes in interest rates, households’
wealth, or consumers’ confidence
16-8
Determinants of Aggregate Demand
• Both investment spending (I) and government
spending (G) are assumed to be exogenous
– Consequently, although the theory does discuss
how changes in I and G affect endogenous
variables such as Y and E, it has no idea what
makes I and G fluctuate
Determinants of Aggregate Demand
• Assumption: The balance on the current account (CA)
increases …
– … when the real exchange rate (q) increases
• Recall that the real exchange rate is the price of foreign products
relative to the price of domestic products: q = EP*/P
– … when disposable income decreases
• more disposable income (Y-T) means more expenditure on foreign
products (imports). Therefore, when Y−T rises, CA falls.
• 𝑪𝑨 = 𝑪𝑨𝟎 + 𝑪𝑨𝒒 ∙ 𝒒 − 𝑪𝑨𝒎 ∙ 𝒀 − 𝑻
16-10
Determinants of Aggregate Demand
• 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇
– 𝐶𝐴𝑞 is the increase in the domestic country’s
current account when the real exchange rate
increases by one unit.
– Any increase (decrease) in the tariff on imported
goods leads to an increase (decrease) in 𝐶𝐴𝑞 .
– Note that 𝐶𝐴𝑞 > 0
16-11
Determinants of Aggregate Demand
• 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇
– 𝐶𝐴𝑚 is the decrease in the domestic country’s
current account (or, net exports) when after-tax
income increases by one unit. When after-tax
income increases by one unit, consumption
spending increases by 𝐶𝑦 units. Part of this
increase in consumption is imported, and this is
denoted 𝐶𝐴𝑚 .
– Therefore, 0 < 𝐶𝐴𝑚 < 𝐶𝑦 , which also means
𝐶𝑦 − 𝐶𝐴𝑚 > 0.
16-12
Determinants of Aggregate Demand
• 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇
– 𝐶𝐴0 is exogenous net exports.
– 𝐶𝐴0 reflects the impact on the domestic country’s
current account of all factors other than the real
exchange rate and after-tax income.
– For example, 𝐶𝐴0 may increase when there is an
increase in the foreign country’s GNP, or the
domestic country increases the tariff on its
imports
16-13
Determinants of Aggregate Demand
• 𝐶 = 𝐶0 + 𝐶𝑦 ∙ 𝑌 − 𝑇
• 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇
• 𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝐶𝐴
• Therefore, 𝐷 = 𝐶0 + 𝐶𝑦 ∙ 𝑌 − 𝑇 + 𝐼 + 𝐺 +
𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇
Short-Run Equilibrium in the Goods
Market
• For the goods market to be in equilibrium,
GNP must equal aggregate demand: 𝒀 = 𝑫
• Therefore, 𝐷 = 𝐶0 + 𝐶𝑦 ∙ 𝑌 − 𝑇 + 𝐼 + 𝐺 +
𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇 becomes 𝒀 =
𝑪𝟎 + 𝑪𝒚 ∙ 𝒀 − 𝑻 + 𝑰 + 𝑮 + 𝑪𝑨𝟎 + 𝑪𝑨𝒒 ∙
𝒒 − 𝑪𝑨𝒎 ∙ 𝒀 − 𝑻
• This equation represents equilibrium in the
domestic country’s goods markets
Y  C0  C y  Y  T   I  G  CA0  CAq  q  CAm  Y  T 
Y  C0  C y  Y  C y  T  I  G  CA0  CAq  q  CAm  Y  CAm  T
Y  C0  C y  CAm  Y  C y  CAm  T  I  G  CA0  CAq  q
Y  C y  CAm  Y  C0  C y  CAm  T  I  G  CA0  CAq  q
1  C
Y
y
 CAm  Y  C0  C y  CAm  T  I  G  CA0  CAq  q
C0  C y  CAm  T  I  G  CA0  CAq  q
1  C
y
 CAm 
 E  P* 

C0  C y  CAm  T  I  G  CA0  CAq  
P 

Y
1  C y  CAm 
Note that we now have an equation in which the domestic country’s GNP (Y) and the
exchange rate of the foreign country’s currency (E) are the only two endogenous
variables; all other variables are exogenous. This is the DD equation.
Goods Market Equilibrium
 E  P* 

C0  C y  CAm  T  I  G  CA0  CAq  
P 

Y
1  C y  CAm 
Note that, for specified values
of all the exogenous variables in
the DD equation, any increase
in E must be accompanied by an
increase in Y, and vice versa.
That is, equilibrium in the goods
market implies a direct relation
between Y and E. This yields the
upward-rising DD curve.
The DD equation
The DD curve
Shifts of the DD Curve
 E  P* 

C0  C y  CAm  T  I  G  CA0  CAq  
P 

Y
1  C y  CAm 
What could cause the DD curve
to shift to the right?
DD2
3
Shifts of the DD Curve
 E  P* 

C0  C y  CAm  T  I  G  CA0  CAq  
P 

Y
1  C y  CAm 
What could cause the DD curve
to shift to the right?
Suppose the DD curve shifts to the right.
Then, note that at any particular value of E,
the value of Y indicated by the DD
equation/curve must increase. For example,
if E = E1 in the diagram, the equilibrium value
of output indicated by the DD
equation/curve must increase from Y1 to Y2.
Now, what would need to happen for Y to
increase when E is unchanged?
DD2
3
Shifts of the DD Curve
 E  P* 

C0  C y  CAm  T  I  G  CA0  CAq  
P 

Y
1  C y  CAm 
What could cause the DD curve
to shift to the right?
Suppose the DD curve shifts to the right.
Then, note that at any particular value of E,
the value of Y indicated by the DD
equation/curve must increase. For example,
if E = E1 in the diagram, the equilibrium value
of output indicated by the DD
equation/curve must increase from Y1 to Y2.
Now, what would need to happen for Y to
increase when E is unchanged?
DD2
3
Shifts of the DD Curve
• So, we see that the DD curve shifts to the right
if:
– There is an increase in C0, I, G, CA0, CAq, or P*, or
– There is a decrease in T or P
• Every one of these shifts represents an
increase in aggregate demand
• So, the DD curve shifts right whenever an
exogenous change boosts aggregate demand
Shifting the DD Curve
•
The DD curve shifts right if:
–
G increases
Simply put, the DD curve shifts right
whenever an exogenous change boosts
aggregate demand
–
T decreases
–
I increases
–
P decreases
–
P* increases
–
C increases for some unknown reason (C0↑)
–
CA increases for some unknown reason (CA0↑, CAq↑)
16-22
We’ve seen this before in Chapter 15. Equilibrium in the foreign currency
markets requires interest rate parity. Equilibrium in the money market
requires equality of money supply and money demand.
THE AA CURVE
Short Run Equilibrium for Assets
• We’ve discussed two asset markets:
1. Ch 14: Foreign exchange market
– interest parity: R = R* + (Ee – E)/E
2. Ch 15: Money market
– money supply equals money demand in
equilibrium: Ms = P × L(R, Y)
16-24
Equilibrium in Asset Markets
• We simplify the money market equilibrium
𝑃∙𝐿0 ∙𝑌
𝑠
equation to 𝑀 =
or equivalently to
𝑌=
𝑀𝑠
𝐿0 ∙𝑃
𝑅
∙𝑅
• The interest parity equation then yields 𝑌 =
𝑀𝑠
𝐿0 ∙𝑃
∙ 𝑅∗ +
𝐸𝑒
𝐸
−1
• This is the AA equation, and it can be turned
into the AA curve
Fig. 17-7: The AA Schedule
𝒆
𝑴𝒔
𝑬
𝒀=
∙ 𝑹∗ +
−𝟏
𝑳𝟎 ∙ 𝑷
𝑬
17-26
Shifts of the AA Curve
• 𝑌=
𝑀𝑠
𝐿0 ∙𝑃
∙
𝑅∗
+
𝐸𝑒
𝐸
−1
– Suppose the economy is initially
at Point 2
– Suppose there is a decrease in Ms
or R* or Ee, or an increase in L0 or
P
– If E stays unchanged at E2, then Y
must decrease
– The economy must go from Point
2 to, perhaps, Point 3
– In other words, a decrease in Ms
or R* or Ee, or an increase in L0 or
P shifts the AA curve left
3
AA2
Shifting the AA Curve
•
The AA curve shifts right if:
–
–
–
–
–
Ms increases
Simply put, the AA curve shifts right
whenever an exogenous change increases
P decreases
money supply or decreases money
e
E increases
demand
R* increases
L decreases for some unknown reason (L0↓)
E
𝒆
𝑴𝒔
𝑬
𝒀=
∙ 𝑹∗ +
−𝟏
𝑳𝟎 ∙ 𝑷
𝑬
E0
E1
Y0
Y1
Y
16-28
All markets must be simultaneously in equilibrium
SHORT-RUN MACROECONOMIC
EQUILIBRIUM
Putting the Pieces Together:
the DD and AA Curves
•
A short-run equilibrium means that there is
equilibrium in all markets:
1. the output market: aggregate demand (D) equals
aggregate output (Y).
2. the foreign exchange market: interest parity holds.
3. the money market: money supply (MS) equals money
demand (Md).
16-30
Fig. 17-8: Short-Run Equilibrium: The
Intersection of DD and AA
The output
market is in
equilibrium
on the DD
curve
The asset
markets are in
equilibrium
on the AA
curve
The short run
equilibrium
occurs at the
intersection
of the DD and
AA curves
17-31
Shifting the AA and DD Curves
•
The DD curve shifts right
if:

G increases

T decreases

I increases

P decreases

P* increases

C increases for some
unknown reason (C0↑)

CA increases for some
unknown reason (CA0↑,
CAq↑)
•
The AA curve shifts right
if:
–
–
–
–
–
Ms increases
P decreases
Ee increases
R* increases
L decreases for some
unknown reason (L0↓)
Knowing how some exogenous change shifts
the DD and AA curves will help us predict
the consequences of the exogenous change.
16-32
Short-run effects of temporary changes in …
MONETARY POLICY
Temporary Changes in Monetary Policy
• Monetary policy: what central banks do to influence the
economy through changes in the money supply (MS).
– Monetary policy primarily affects asset markets (the AA curve).
• Temporary policy changes are expected to be reversed in the
near future and thus do not affect expectations about
exchange rates in the long run.
– Specifically, temporary changes in MS do not affect Ee.
• Expansionary monetary policy: MS↑
• Contractionary monetary policy: MS↓
16-34
Shifting the AA and DD Curves
•
The DD curve shifts right
if:

G increases

T decreases

I increases

P decreases

P* increases

C increases for some
unknown reason (C0↑)

CA increases for some
unknown reason (CA0↑,
CAq↑)
•
The AA curve shifts right
if:
–
–
–
–
–
Ms increases
P decreases
Ee increases
R* increases
L decreases for some
unknown reason (L0↓)
Knowing how some exogenous change shifts
the DD and AA curves helps us predict the
consequences of the exogenous change.
16-35
Temporary Changes in Monetary Policy
• When there is an increase in the supply of money
– The AA shifts up (right) and DD is unaffected.
– Both E and Y increase
– R decreases
• As Ee is unaffected when the change in Ms is temporary—see next
three slides—the increase in E leads to a decrease in R; recall R =
R* + (Ee/E) – 1.
E
DD
E0
AA
Y0
Y
16-36
Effect of Monetary Policy on q
• Recall that the real exchange rate is 𝑞 = 𝐸 ∙
𝑃∗ /𝑃
• We just saw that when the domestic money
supply increases, the foreign currency
increases in value: Ms↑ implies E↑
• Now, P and P* are exogenous.
• Although exogenous variables can change, a
change in one variable cannot cause another
variable that is exogenous to change.
Effect of Monetary Policy on q
• Therefore,
– as Ms↑ implies E↑, and
– as P and P* are exogenous, it follows that
– 𝑞 = 𝐸 ∙ 𝑃∗ /𝑃 must also ↑
The Exchange Rate in the Future
• How should we think about Ee?
– It is what people today expect the exchange rate
to be in the future
• When there is a temporary change in an
exogenous variable, there is no reason to
expect the future value of the exchange rate
to be affected
• Therefore, we assume that Ee is unaffected by
temporary changes in the exogenous variables
The Exchange Rate in the Future
• But when there is a permanent change in an
exogenous variable, it is reasonable to expect
the future value of the exchange rate to
change
– We saw in Ch. 16 that 𝐸 =
𝑞∙𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗
𝐿0 ∙𝑌 𝑓 ∙𝑃∗
in
the long run
– So, if there are permanent changes in any of the
variables on the right-hand side, we must assume
that Ee would change. Right away!
The Exchange Rate in the Future
• To sum up, in short-run analysis of temporary
changes in exogenous variables we treat Ee as
an exogenous variable.
– Ee may change, just like any other exogenous
variable may change. But changes in some other
exogenous variable cannot cause Ee to change
• In short-run analysis of permanent changes in
exogenous variables we treat Ee as an
endogenous variable.
Effect of Monetary Policy on R
• In Ch. 14 we saw the interest parity equation:
𝑅 = 𝑅∗ +
𝐸𝑒
𝐸
−1
• We just saw that Ms↑ implies E↑
• As R* and Ee are exogenous, a change in Ms
cannot cause them to change
• Therefore, Ms↑ implies R↓
• Expansionary monetary policy reduces
interest rates
Two Ways to Analyze CA
• There are two ways to figure out the effect of
a change in an exogenous variable on a
country’s current account
• Method 1: 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙
𝑌−𝑇
We will return to Ch. 16 and use this to
analyze the long-run behavior of CA.
Two Ways to Analyze CA
• To see Method 2, recall that 𝑌 = 𝐶 + 𝐼 + 𝐺 +
𝐶𝐴 in goods market equilibrium.
• So, 𝐶𝐴 = 𝑌 − 𝐶 − 𝐼 − 𝐺
• Recall that 𝐶 = 𝐶0 + 𝐶𝑦 ∙ 𝑌 − 𝑇 . Therefore,
• Method 2: 𝐶𝐴 = 𝑌 − 𝐶0 − 𝐶𝑦 ∙ 𝑌 − 𝑇 − 𝐼 −
𝐺 = 1 − 𝐶𝑦 ∙ 𝑌 − 𝐶0 + 𝐶𝑦 ∙ 𝑇 − 𝐼 − 𝐺
We will return to Ch. 16 and use this to
analyze the long-run behavior of CA.
Effect of Monetary Policy on CA
• Use Method 2: 𝐶𝐴 = 1 − 𝐶𝑦 ∙ 𝑌 − 𝐶0 + 𝐶𝑦 ∙
𝑇−𝐼−𝐺
• We have seen that an increase in Ms causes Y
to increase.
• Therefore, CA must increase.
• That is, an increase in the supply of money,
leads to an increase in the current account
R*↑ and E ↑ have the
balance (or, net exports)
e
same effect, as does a fall
in money demand (L0↓).
16-45
Exogenous Money Demand
• Recall the AA and DD equations:
• AA: 𝑌 =
•
• DD:
𝑀𝑠
𝐿0 ∙𝑃
∙ 𝑅∗ +
𝐸𝑒
𝐸
−1
 E  P* 

C0  C y  CAm  T  I  G  CA0  CAq  
P 

Y
1  C y  CAm 
• It should be clear that the effects of L0↓ are
the same as the effects of Ms↑ that we have
just analyzed [Can you verify this?]
Summary: Short Run Predictions,
Flexible Exchange Rate System
DD
AA
Y
CA
q
E
R
Ms
→
+
+
+
+
−
L0
←
−
−
−
−
+
Here’s a very informal ‘story’ about the effects of expansionary monetary policy: if
the domestic central bank prints more money, the value of the domestic currency will
decrease and so the value of the foreign currency will increase (E↑). This makes
foreign goods more expensive (q↑). As a result, the domestic net exports increase
(CA↑). This increase in net exports boosts domestic aggregate demand, which raises
output (Y↑). Also, when more money is printed, domestic interest rates fall (R↓).
The exogenous variables—policy variables and
‘shocks’—are listed on the first column and the
endogenous unknowns are listed on the first row.
The 2nd and 3rd columns show how the DD and AA
curves are shifted by an increase in the exogenous
variables.
The predictions above are for
temporary changes in the
exogenous variables.
Fig. 17-10: Effects of a Temporary
Increase in the Money Supply
R*↑ and Ee↑ have the
same effect on AA and DD.
And so does a fall in
money demand (L0↓).
17-48
Changes in Ee and R*
• Any increase in Ee, the expected future value
of the foreign currency, or in R*, the foreign
interest rate, cause the same shifts as
expansionary monetary policy: the AA curve
shifts rightward and the DD curve is
unaffected
• Therefore, Y↑ and E↑.
• As P and P*, being exogenous, are unaffected,
E↑ implies q↑
Changes in Ee and R*
• Recall that the money market’s equilibrium
𝑃∙𝐿0 ∙𝑌
𝑠
equation is 𝑀 =
or, equivalently, 𝑅 =
𝐿0 ∙𝑃∙𝑌
𝑀𝑠
𝑅
• As L0, P, and Ms, being exogenous, are
unaffected by increases in Ee or R*, the fact
that Y↑ implies R↑
Changes in Ee and R*
• Recall that 𝐶𝐴 = 1 − 𝐶𝑦 ∙ 𝑌 − 𝐶0 + 𝐶𝑦 ∙ 𝑇 −
𝐼−𝐺
• We have just seen that Ee↑ or R*↑ causes Y↑
• As I and G are exogenous and, therefore,
unaffected by changes in Ee or R*, it must be
that CA↑
Summary: Short Run Predictions,
Flexible Exchange Rate System
DD
AA
Y
CA
q
E
R
Ms
→
+
+
+
+
−
L0
←
−
−
−
−
+
Ee
→
+
+
+
+
+
R*
→
+
+
+
+
+
Here’s an informal ‘story’ about the effects of increases in R* and Ee: When the
foreign interest rate rises and the expected future value of the foreign currency rises,
keeping money in foreign banks becomes more attractive. So people sell the
domestic currency and buy the foreign currency to move money abroad. So the
domestic
currency
loses value and
the foreign
value (E↑).
This
The exogenous
variables—policy
variables
and currency
Thegains
predictions
above
aremakes
for
foreign
goods
more
expensive
(q↑).
Consequently
the
domestic
country’s
net
exports
‘shocks’—are listed on the first column and the
temporary changes in the
increase
(CA↑).
This
boosts
domestic
aggregate
demand
and output
(Y↑). The rise in
endogenous unknowns are listed on the first row.
exogenous
variables.
output
causes money demand to rise, which means less lending. Less lending pushes
The 2nd and 3rd columns show how the DD and AA
up the domestic interest rate (R↑). In short, everything increases!
curves are shifted by an increase in the exogenous
variables.
Short-run effects of temporary changes in …
FISCAL POLICY
Temporary Changes in Fiscal Policy
• Fiscal policy is what governments do to influence the
economy through changes in government spending (G) and
taxes (T).
– Fiscal policy primarily influences the goods market (the DD curve).
• Temporary policy changes are expected to be reversed in the
near future and thus do not affect expectations about
exchange rates in the long run.
– Specifically, temporary changes in G and T do not affect Ee.
• Expansionary fiscal policy: G↑ and/or T↓
• Contractionary fiscal policy: G↓ and/or T ↑
16-54
Temporary Changes in Fiscal Policy
• An increase in government purchases or a decrease
in taxes increases aggregate demand and output.
– The DD curve shifts right.
– Higher output increases money demand, and
– thereby increases interest rates,
– causing an increase in the value of the domestic currency
(a fall in E).
16-55
Shifting the AA and DD Curves
•
The DD curve shifts right
if:

G increases

T decreases

I increases

P decreases

P* increases

C increases for some
unknown reason (C0↑)

CA increases for some
unknown reason (CA0↑,
CAq↑)
•
The AA curve shifts right
if:
–
–
–
–
–
Ms increases
P decreases
Ee increases
R* increases
L decreases for some
unknown reason (L0↓)
Knowing how some exogenous change shifts
the DD and AA curves will help us predict
the consequences of the exogenous change.
16-56
Fig. 17-11: Effects of a Temporary
Fiscal Expansion G↑ and/or T↓
C0↑, CA0↑, CAq↑, P*↑ and
I↑ also shift DD to the right
and leave AA unaffected. So,
they too have the same
effect: Y↑, E↓, and R↑.
17-57
Effect of Temporary Fiscal Stimulus
• We just saw that expansionary fiscal policy—
that is, G↑ and/or T↓—causes E↓ and Y↑.
– Therefore, Y – T↑
• As P and P* are exogenous, they are unaffected
by changes in G and T.
• Therefore, 𝑞 = 𝐸 ∙ 𝑃∗ /𝑃, which is the real
exchange rate, must decrease: q↓
This argument also applies for C0↑,
CA0↑, CAq↑ and I↑. So, they too
cause q↓. [Verify]
16-58
Effect of Temporary Fiscal Stimulus
∗
• Recall that 𝑅 = 𝑅 +
𝐸𝑒
𝐸
− 1 (interest parity)
• We just saw that a temporary fiscal stimulus
reduces E
• But it cannot affect R* and Ee, which are
exogenous
• It follows that the domestic interest rate must
increase: R↑
This argument also applies for C0↑,
CA0↑, CAq↑, P*↑ and I↑. So, they
too cause R↑. [Verify]
Effect of Temporary Fiscal Stimulus
• Recall that there are two ways of expressing
the domestic country’s net exports (or, current
account):
• Method 1: 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙
𝑌−𝑇
• Method 2: 𝐶𝐴 = 1 − 𝐶𝑦 ∙ 𝑌 − 𝐶0 + 𝐶𝑦 ∙ 𝑇 −
𝐼−𝐺
16-60
Effect of Temporary Fiscal Stimulus
• We just saw that expansionary fiscal policy
causes Y↑ and q↓
• Using 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇 ,
it follows that CA↓
• That is, expansionary fiscal policy reduces a
country’s current account balance (also called
net exports and trade surplus)
This argument also applies for C0↑ and
I↑. So, they too cause CA↓. [Verify]
16-61
Effect of Temporary Fiscal Stimulus
• Recall the AA and DD equations:
• AA: 𝑌 =
•
• DD:
𝑀𝑠
𝐿0 ∙𝑃
∙ 𝑅∗ +
𝐸𝑒
𝐸
−1
 E  P* 

C0  C y  CAm  T  I  G  CA0  CAq  
P 

Y
1  C y  CAm 
• It should be clear that the effects of C0↑,
CA0↑, CAq↑, P*↑, and I↑ on Y, E, R and q are
the same as the effects of G↑ that we have
just analyzed [Can you verify this?]
Summary: Short Run Predictions,
Flexible Exchange Rate System
DD
AA
Y
CA
q
E
R
G, I, C0
→
+
−
−
−
+
T
←
−
+
+
+
−
Here’s an informal ‘story’ of the effects of expansionary fiscal policy: Fiscal stimulus
raises domestic aggregate demand and output (Y↑). This raises money demand,
meaning people become less willing to lend. This raises the domestic interest rate
(R↑). So people sell foreign currencies and buy the domestic currency to move their
wealth to domestic banks. This raises the value of the domestic currency and reduces
the value of the foreign currency (E↓). This makes foreign goods cheaper (q↓). Both
the rising income at home and the cheaper foreign goods reduce net exports (CA↓).
The exogenous variables—policy variables and
‘shocks’—are listed on the first column and the
endogenous unknowns are listed on the first row.
The 2nd and 3rd columns show how the DD and AA
curves are shifted by an increase in the exogenous
variables.
The predictions above are for
temporary changes in the
exogenous variables.
Change in Foreign Prices (P*)
• We saw earlier that P*↑ causes the DD curve
to shift right and has no effect on the AA curve
• Therefore, E↓ and Y↑.
• And, from 𝐶𝐴 = 1 − 𝐶𝑦 ∙ 𝑌 − 𝐶0 + 𝐶𝑦 ∙ 𝑇 −
𝐼 − 𝐺, it follows that CA↑
• From 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇 ,
it then follows that q↑ [Can you verify this?]
Change in Foreign Prices (P*)
∗
• Recall that 𝑅 = 𝑅 +
𝐸𝑒
𝐸
− 1 (interest parity)
• We just saw that a temporary increase in P*
reduces E
• But it cannot affect R* and Ee, which are
exogenous
• It follows that the domestic interest rate must
increase: R↑
Change in Import Tariffs (CAq)
• We saw earlier that CAq↑ causes the DD curve
to shift right and has no effect on the AA curve
• Therefore, E↓ and Y↑.
• And, from 𝐶𝐴 = 1 − 𝐶𝑦 ∙ 𝑌 − 𝐶0 + 𝐶𝑦 ∙ 𝑇 −
𝐼 − 𝐺, it follows that CA↑
• From 𝑞 = 𝐸 ∙ 𝑃∗ /𝑃, it then follows that q↓
[Can you verify this?]
Change in Import Tariffs (CAq)
∗
• Recall that 𝑅 = 𝑅 +
𝐸𝑒
𝐸
− 1 (interest parity)
• We just saw that a temporary increase in P*
reduces E
• But it cannot affect R* and Ee, which are
exogenous
• It follows that the domestic interest rate must
increase: R↑
An Increase in Foreign GNP (CA0↑)
• We have seen before that CA0↑ causes Y↑,
E↓, R↑, and q↓
• Then, from 𝐶𝐴 = 1 − 𝐶𝑦 ∙ 𝑌 − 𝐶0 + 𝐶𝑦 ∙
𝑇 − 𝐼 − 𝐺, it follows that CA↑
Shifting the AA and DD Curves
•
The DD curve shifts right
if:

G increases

T decreases

I increases

P decreases

P* increases

C increases for some
unknown reason (C0↑)

CA increases for some
unknown reason (CA0↑,
CAq↑)
•
The AA curve shifts right
if:
–
–
–
–
–
Ms increases
P decreases
Ee increases
R* increases
L decreases for some
unknown reason (L0↓)
Knowing how some exogenous change shifts
the DD and AA curves will help us predict
the consequences of the exogenous change.
16-71
Change in Domestic Prices (P)
• Recall that P↓ causes both AA and DD curves
to shift rightward
• Therefore, it is clear that Y↑
• But E could decrease, stay unchanged, or
increase, as in the three diagrams below
E
E
DD
AA
E
DD
AA
Y
DD
AA
Y
Y
Change in Domestic Prices (P)
• As Y↑, it follows from 𝐶𝐴 = 1 − 𝐶𝑦 ∙ 𝑌 − 𝐶0 +
𝐶𝑦 ∙ 𝑇 − 𝐼 − 𝐺 that CA↑
• From 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇 , it
then follows that q↑ [Can you verify this?]
• Finally, the interest parity equation (𝑅 = 𝑅 ∗ +
𝐸𝑒
− 1) implies that, as Ee and R* are exogenous
𝐸
and, therefore, unaffected by P↓, the ambiguous
behavior of E implies that R too could decrease,
stay unchanged, or increase
Summary: Short Run Predictions,
Flexible Exchange Rate System
DD
AA
Y
CA
q
E
R
Ms
→
+
+
+
+
−
L0
←
−
−
−
−
+
Ee
→
+
+
+
+
+
R*
→
+
+
+
+
+
G, I, C0
→
+
−
−
−
+
CA0
→
+
+
−
−
+
T
←
−
+
+
+
−
P*
→
+
+
+
−
+
CAq
→
+
+
−
−
+
P
←
←
−
−
The exogenous variables—policy variables and
‘shocks’—are listed on the first column and the
endogenous unknowns are listed on the first row.
−
?
?
The predictions above are for
temporary changes in the
exogenous variables.
The 2nd and 3rd columns show how the DD and AA curves are shifted by an increase in the exogenous variables.
Summary: Short Run Predictions,
Flexible Exchange Rate System
DD
AA
Y
CA
q
E
R
Ms
→
+
+
+
+
−
L0
←
−
−
−
−
+
Ee
→
+
+
+
+
+
R*
→
+
+
+
+
+
G, I, C0
→
+
−
−
−
+
CA0
→
+
+
−
−
+
T
←
−
+
+
+
−
P*
→
+
+
+
−
+
CAq
→
+
+
−
−
+
P
←
−
−
−
?
?
←
Q: If the economy is in a recession—with falling output and rising unemployment—what kind
of monetary and fiscal policy would be appropriate?
A: Expansionary fiscal policy (G↑ and/or T↓) and expansionary monetary policy (Ms↑)
Summary: Short Run Predictions,
Flexible Exchange Rate System
DD
AA
Y
CA
q
E
R
Ms
→
+
+
+
+
−
L0
←
−
−
−
−
+
Ee
→
+
+
+
+
+
R*
→
+
+
+
+
+
G, I, C0
→
+
−
−
−
+
CA0
→
+
+
−
−
+
T
←
−
+
+
+
−
P*
→
+
+
+
−
+
CAq
→
+
+
−
−
+
P
←
−
−
−
?
?
←
Q: If the economy has a huge trade deficit and it has become necessary to increase net
exports (CA), what kind of monetary and fiscal policy would be appropriate?
A: Contractionary fiscal policy (G↓ and/or T↑) and expansionary monetary policy (Ms↑)
Summary: Short Run Predictions,
Flexible Exchange Rate System
DD
AA
Y
CA
q
E
R
Ms
→
+
+
+
+
−
L0
←
−
−
−
−
+
Ee
→
+
+
+
+
+
R*
→
+
+
+
+
+
G, I, C0
→
+
−
−
−
+
CA0
→
+
+
−
−
+
T
←
−
+
+
+
−
P*
→
+
+
+
−
+
CAq
→
+
+
−
−
+
P
←
−
−
−
?
?
←
Q: If foreign prices or foreign interest rates decrease, what kind of monetary and fiscal policy
would keep output and unemployment stable in the domestic country?
A: Expansionary fiscal policy (G↑ and/or T↓) and expansionary monetary policy (Ms↑)
We need to return briefly to Chapter 16 for this
LONG-RUN BEHAVIOR OF CA
Requires a quick detour of Chapter 16
SHORT-RUN EFFECTS OF PERMANENT
CHANGES IN GOVERNMENT POLICY
The Exchange Rate in the Future
• When there is a permanent change in an
exogenous variable, it is reasonable to expect
the future value of the exchange rate to
change
The Exchange Rate in the Future
• We saw in Ch. 16 that in the long run
–𝐸=
–𝑞=
𝑞∙𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑝 𝑔 −𝜋∗
𝐿0 ∙𝑌 𝑝 ∙𝑃∗
1− 𝐶𝑦 −𝐶𝐴𝑚 ∙𝑌 𝑓 + 𝐶𝑦 −𝐶𝐴𝑚 ∙𝑇− 𝐶0 +𝐼+𝐺+𝐶𝐴0
𝐶𝐴𝑞
– So, if there are permanent changes in any of the
variables on the right-hand side, we must assume
that Ee would change as indicated. Right away!
Fiscal Policy
• Note from the previous slide that a permanent
increase in G and/or a permanent decrease in
T will cause both q and E to decrease in the
long run
• Therefore, we should expect Ee to decrease in
the short run, in fact immediately
• G↑ and/or T↓ shifts the DD curve right
• And Ee ↓ shifts the AA curve left
Shifting the AA and DD Curves
•
The DD curve shifts right
if:

G increases

T decreases

I increases

P decreases

P* increases

C increases for some
unknown reason (C0↑)

CA increases for some
unknown reason (CA0↑,
CAq↑)
•
The AA curve shifts right
if:
–
–
–
–
–
Ms increases
P decreases
Ee increases
R* increases
L decreases for some
unknown reason (L0↓)
Knowing how some exogenous change shifts
the DD and AA curves will help us predict
the consequences of the exogenous change.
16-83
Fiscal Policy in the Short Run
• When expansionary fiscal policy is temporary,
the DD curve shifts right and the AA curve is
unaffected
• When expansionary fiscal policy is permanent,
the DD curve shifts right and the AA curve
shifts left
• Therefore, expansionary fiscal policy is less
effective when it is permanent!!
Permanent Increase in Money Supply
• The AA curve shifts right because of the increase
in MS. The equilibrium moves from point 1 to
point 3 in Fig 17-14.
• In the long run, E will rise (See 3 slides back)
• This will have the immediate effect of raising Ee.
• The increase in Ee shifts the AA curve to the right
again.
• The equilibrium moves from point 3 to point 2.
• Both E and Y increase more for a permanent
increase in MS than for a temporary increase in
MS.
16-85
Fig. 17-14: Short-Run Effects of a Permanent Increase in
the Money Supply
17-86
Permanent ↑ in Ms: Overshooting?
AA1 is the initial AA curve
AA2 is AA1 plus effect of Ee↑ caused by permanent ↑ in Ms.
AA3 is AA2 plus effect of Ms/P↑ caused by permanent ↑ in Ms.
In the long run, Ms/P returns to original level. So, the economy goes
from the lower of the two green dots to a black dot in the short run, and
to the higher of the two green dots in the long run.
E
DD2
DD1
E
AA3
AA2
AA1
Yp
Overshooting
Y
Yp
DD2 E
DD1
DD2
DD1
AA3
AA2
AA1
AA3
AA2
AA1
Y
Neither over nor under!
Yp
Undershooting
Y
16-87