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
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)
16-4
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.
16-5
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.
16-6
Determinants of Aggregate Demand (cont.)
• Aggregate demand is therefore expressed as:
D = C(Y – T) + I + G + CA(E×P*/P, Y – T)
Consumption
depends on
disposable
income
Investment and
government
purchases, both
exogenous
Current account
depends on the real
exchange rate and
disposable income.
• Or more simply:
D = D(E×P*/P, Y – T, I, G)
16-9
Short Run Equilibrium for Aggregate Demand
and Output
Value of output,
income from
production
Aggregate demand as a function of the
real exchange rate, disposable income,
investment, government purchases
16-12
Goods Market Equilibrium
Goods Market Equilibrium
Goods Market Equilibrium: DD Curve
17-15
Goods Market Equilibrium: Shifts of
the DD Curve
Suppose the economy is initially at Point 1.
Suppose there is a tax hike (T↑), but
output is still at Y1. Then, C will decrease.
Let’s say C decreases by $100. This will
require CA to increase by $100. But T ↑, by
itself, will increase CA by less than $100.
Why? When C falls by $100, the
consumption of imported goods would fall
by less: say, by $55. So, the tax cut, by itself,
would increase CA by only $55.
Therefore, to make CA increase by another
$45, E must increase. So, the tax hike takes
the economy from Point 1 to Point 3.
In other words, the tax hike shifts the DD
curve upward and to the left.
DD2
3
17-16
Goods Market Equilibrium: Shifts of
the DD Curve
Suppose the economy is initially at Point 2.
Suppose I or G increases (I + G↑), but
output is still at Y2. Then, CA must decrease.
With unchanged Y, this requires a decrease
in E. Therefore, if I or G increases and Y is
unchanged, then the economy must move
from Point 2 to Point 3. In other words, if I
or G increases, the DD curve must shift
downward or to the right.
DD2
3
17-17
Goods Market Equilibrium: Shifts of
the DD Curve
Suppose the economy is initially at Point 2.
Suppose P* increases or P decreases (P*/P
↑), but output is still at Y2. Then, CA must
stay unchanged. With Y and T unchanged,
the only way CA can remain unchanged in
spite of P*/P ↑ is if E decreases enough to
keep the real exchange rate unchanged.
Therefore, if P* increases or P decreases
and Y is unchanged, then the economy
must move from Point 2 to Point 3. In other
words, if P* increases or P decreases , the
DD curve must shift downward or to the
right.
DD2
3
17-18
Fig. 17-2: The Determination of Output
in the Short Run
Aggregate
demand is
greater than
production:
firms increase
output
Output is greater
than aggregate
demand: firms
decrease output
17-19
Short Run Equilibrium and the Exchange Rate:
DD Schedule
• How does the value of the foreign currency (E) affect the short
run equilibrium of aggregate demand and output?
• Domestic and foreign price levels (P and P*) are assumed fixed
in the short run.
• Therefore, a rise in the nominal exchange rate (E) makes
foreign goods more expensive relative to domestic goods. That
is, q = E × P*/P increases when E increases.
• As a result, CA increases and, therefore, D increases. That is, D
increases when E increases. See Fig 17-3.
• In equilibrium, Y = D. Therefore, Y increases when E increases.
• This gives the DD curve. See Fig 17-4.
Y = D(E×P*/P, Y – T, I, G)
16-20
Fig. 17-3: Output Effect of a Currency
Depreciation with Fixed Output Prices
Y = D(E×P*/P, Y – T, I, G)
17-21
Fig. 17-4:
Deriving the
DD Schedule
Y = D(E×P*/P, Y – T, I, G)
17-22
Shifting the DD Curve
•
Changes in the exchange rate cause movements
along a DD curve. Other changes may cause it to
shift:
1. Changes in G: more government purchases cause
higher aggregate demand and output in
equilibrium. Output increases for every exchange
rate: the DD curve shifts right.
16-23
Fig. 17-5: Government Demand and the Position of the
DD Schedule
An increase in G causes
the DD curve to shift to
the right.
The same rightward shift of
the DD curve happens if:
•I increases
•T decreases
•P*/P increases
Y = D(E×P*/P, Y – T, I, G)
17-24
Shifting the DD Curve
•
The DD curve shifts right if:
–
G increases
–
T decreases
–
I increases
–
P decreases
–
P* increases
–
C increases for some unknown reason
–
CA increases for some unknown reason
Y = D(E×P*/P, Y – T, I, G)
16-25
THE AA CURVE
Short Run Equilibrium for Assets
• We consider two asset markets when
considering asset market equilibrium:
1. Ch 14: Foreign exchange market
– interest parity: R = R* + (Ee – E)/E
2. Ch 15: Money market
– real money supply and demand determine
equilibrium: Ms/P = L(R, Y)
16-27
Equilibrium in Asset Markets
Equilibrium in Asset Markets
3
AA2
What makes the value of the euro (E) change?
Note the inverse
relation between Y
and E. This yields
another curve
linking Y and E: the
AA curve.
M/P
(-)
Y
(+)
(-)
Domestic
preference
for cash
(+)
M*/P*
(-)
Y*
Foreign preference
for cash
R
(+)
(+)
R*
E
(+)
(+)
Ee
16-30
Fig. 17-7: The AA Schedule
e
E
R  R* 
1
E
s
M
 L ( R, Y )
P
17-31
Recap: What makes (E), the value of the foreign
currency, change?
Note the inverse
relation between Y
and E. This yields
another curve linking
Y and E: the AA
curve.
M/P
(-)
Y
e
E
RR 
1
E
Ms
 L ( R, Y )
P
*
(+)
(-)
Domestic
preference
for cash
(+)
M*/P*
(-)
Y*
Foreign preference
for cash
R
(+)
(+)
R*
E
(+)
But E is also
affected by
changes in
M/P, Ee, and L,
the preference
for cash.
(+)
Ee
16-32
Shifting the AA Curve
•
The AA curve shifts right if:
–
–
–
–
–
e
Ms increases
E
*
RR 
1
P decreases
E
Ee rises
Ms
 L ( R, Y )
R* rises
P
L decreases for some unknown reason
E
E0
E1
Y0
Y1
Y
16-33
SHORT-RUN MACROECONOMIC
EQUILIBRIUM
Putting the Pieces Together:
the DD and AA Curves
•
A short run equilibrium means that the exchange
rate (E) and output (Y) are such that there is
equilibrium in:
1. the output market: aggregate demand (D) equals
Y = D(E×P*/P, Y – T, I, G)
aggregate output (Y).
2. the foreign exchange market: interest parity holds.
Ee
RR 
1
E
*
3. the money market: real money supply (MS/P) equals
real money demand (L).
Ms
 L ( R, Y )
P
16-35
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
17-36
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

CA increases for some
unknown reason
•
The AA curve shifts right
if:
–
–
–
–
–
Ms increases
P decreases
Ee rises
R* rises
L decreases for some
unknown reason
Knowing how some specified change shifts
the DD and AA curves will help us predict
the consequences of the specified change.
16-37
SHORT-RUN EFFECTS OF TEMPORARY
CHANGES IN GOVERNMENT POLICY
Temporary Changes in
Monetary and Fiscal Policy
• Monetary policy: policy in which the central bank influences
the money supply (MS).
– Monetary policy primarily influences asset markets.
• Fiscal policy: policy in which governments influence the
amount of government purchases (G) and taxes (T).
– Fiscal policy primarily influences aggregate demand (D).
• 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, G, and T do not affect Ee.
16-39
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

CA increases for some
unknown reason
•
The AA curve shifts right if:
–
Ms increases
–
P decreases
–
Ee rises
–
R* rises
–
L decreases for some
unknown reason
16-40
Temporary Changes in Monetary Policy
• When there is an increase in the supply of money
– The AA shifts up (right).
– Both E and Y increase
– R decreases
• As Ee is unaffected when the change in Ms is temporary, the
increase in E leads to a decrease in R; recall R = R* + (Ee – E)/E.
E
DD
E0
Y0
Y
16-41
Fig. 17-10: Effects of a Temporary
Increase in the Money Supply
R*↑ and Ee ↑ have the
same effect, as does a
fall in money demand
(L).
17-42
Effect of Temporary MS↑ on CA
• Goods market equilibrium (DD curve):
Y = C(Y – T) + I + G + CA.
• An increase in Ms causes Y to increase.
• But C(Y – T) increases less than Y does.
• Therefore, CA must increase.
• That is, an increase in the supply of money,
leads to an increase in the current account
balance (or, net exports)
16-43
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: they shift the
AA curve rightward and do not affect the DD
curve
• Therefore, Y↑ and E↑.
• As P and P*, being exogenous, are unaffected,
E↑ implies q↑
Changes in Ee and R*
Changes in Ee and R*
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 real money demand, and
– thereby increases interest rates,
– causing an increase in the value of the domestic currency
(a fall in E).
16-47
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

CA increases for some
unknown reason
•
The AA curve shifts right if:
–
Ms increases
–
P decreases
–
Ee rises
–
R* rises
–
L decreases for some
unknown reason
16-48
Fig. 17-11: Effects of a Temporary
Fiscal Expansion G ↑ and/or T ↓
P*↑ and I↑ have the same
effect, as do shocks that
increase C and CA.
E↓ implies R↑ because R
= R* + Ee/E - 1.
17-49
Effect of G↑ and/or T↓ on CA
• When G↑ and/or T↓ — this is called
expansionary fiscal policy — E↓ and Y↑.
• Therefore, CA↓.
• Expansionary (contractionary) fiscal policy
reduces (increases) net exports.
16-50
Fig. 17-12: Maintaining Full Employment After a
Temporary Fall in World Demand for Domestic Products
Temporary fall in world demand
for domestic products reduces
output below its normal level
Temporary
monetary
expansion could
depreciate the
domestic
currency
Temporary fiscal policy could reverse
the fall in aggregate demand and
output
17-51
Fig. 17-13: Policies to Maintain Full Employment After a Money
Demand Increase
Temporary monetary policy could
increase money supply to match
money demand
Increase in money
demand raises
interest rates and
appreciates the
domestic currency
Temporary fiscal policy could increase
aggregate demand and output
17-52
Effects of an increase in investment
• Simply put, the effects of I↑ are exactly the
same as those of G↑
• Therefore, we can predict that if G↑ and/or
I↑, then E↓, q↓, Y↑, R↑, and CA↓.
Effects of a change in foreign prices
• We saw three slides back that P*↑ causes the
DD curve to shift right and has no effect on
the AA curve
• Therefore, E↓ and Y↑.
• And, following the same steps as in our
discussion of the effects of Ee↑ and R*↑, we
can prove 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

CA increases for some
unknown reason
•
The AA curve shifts right if:
–
Ms increases
–
P decreases
–
Ee rises
–
R* rises
–
L decreases for some
unknown reason
16-55
Effects of a change in domestic prices
• Recall that P↓ causes both AA and DD curves
to shift rightward
• Therefore, Y↑ is certain
• 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
Effects of a change in domestic prices
Summary: Short Run Predictions,
Flexible Exchange Rate System
DD
AA
Y
NX
q
E
R
I, G
→
+
−
−
−
+
T
←
−
+
+
+
−
→
+
+
+
+
−
←
−
−
−
?
?
→
+
+
+
+
+
+
+
+
−
+
+
+
+
+
+
Ms
P
←
Ee
P*
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.
SHORT-RUN EFFECTS OF PERMANENT
CHANGES IN GOVERNMENT POLICY
Permanent Changes in Monetary and Fiscal
Policy
• Permanent policy changes modify people’s
expectations about future exchange rates (Ee) …
• … when they change the long-run value of E.
16-60
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 Table 16-1.
• 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 in
Fig 17-14.
• Both E and Y increase more for a permanent
increase in MS than for a temporary increase in
MS.
16-61
Fig. 17-14: Short-Run Effects of a Permanent Increase in
the Money Supply
17-62
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 a green dot 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
Yf
Overshooting
Y
Yf
DD2 E
DD1
DD2
DD1
AA3
AA2
AA1
AA3
AA2
AA1
Y
Neither over nor under!
Yf
Undershooting
Y
16-64
Macroeconomic Policies and the Current
Account
• By recalling the effects of various policies on
the real dollar/euro exchange rate (q = EP*/P)
and on disposable income (Yd = Y − T), we can
figure out their effects on the current account
(CA).
16-65