Macroeconomics
Chamberlin and Yueh
Chapter 13
Lecture slides
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Aggregate Demand and Aggregate
Supply in the Open Economy
• The AD-CCE-BT (Salter-Swan) Model
•
Competitiveness and the Trade Balance
•
Aggregate Demand and Competitiveness
•
The NAIRU and Long Run Aggregate
Supply in the Open Economy
•
The Trade Balance and the Sustainable
Level of Output
•
Equilibrium in the Salter-Swan model
• Achieving a target level of output
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
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Learning Objectives
• Understand how to construct and use the
AD-CCE-BT or Salter-Swan model to
analyse an open economy
• Describe how prices and the NAIRU are
determined in an open economy
• Identify the sustainable level of output for an
economy
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Open economy version of the AD-AS model
• The open economy version of the AD-AS model is
commonly known as the Salter-Swan model.
• It consists of three lines, each representing the demand,
supply and external parts of the economy.
• The Aggregate Demand schedule (AD) is essentially the
same as that in the closed economy, except now of course
with the addition of net exports.
• The Aggregate Supply schedule is once again derived from
the equilibrium in the labour market. This is known as the
Competing Claims Equilibrium (CCE), as real wage
bargaining seeks to divide output between firms, workers
and foreigners.
• Finally, external equilibrium is represented by equilibrium
in the balance of trade. This is exactly the same as the BT
schedule derived previously.
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The AD-CCE-BT (Salter-Swan) Model
• It consists of three equilibrium relationships examining the
links between competitiveness and in turn, the trade
balance, aggregate demand, and aggregate supply.
• Competitiveness and the Trade Balance -- Exports reflect
the demand for domestically produced goods from overseas
residents and is a positive function of the level of
competitiveness and the overseas level of income:
(13.1)

• Y* is the overseas level
income
and
is the propensity


X  xof

Y
Y
to consume domestic goods, which is positively
related to
xY
the real exchange rate.


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Competitiveness and the Trade
Balance
• Imports represent the demand from domestic firms and
households for goods and service produced overseas and is
determined by domestic income and the marginal
propensity to import: M  mY  Y
(13.2)
• The propensity to import is a function – this time negative –
of the real exchange rate.
• The relationship between imports and the real exchange rate
is complicated slightly by terms of trade effects, which
work in the opposite direction to the competitiveness
effects. A real appreciation, by making foreign goods
cheaper, would mean that the same quantity of goods and
services could be imported at a lower cost.
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Competitiveness and the Trade
Balance
• The trade balance (BT) is therefore the value of real
exports (13.1) minus the value of imports (13.2):
(13.3)
BT  xY   Y   mY  Y
• The trade balance is in equilibrium when BT=0, or where
exports are equal to imports. From (13.3), this implies:
(13.4)
xY  Y   mY  Y

• This relationship (13.4) can be rearranged to give the level
of income where the trade balance is in equilibrium YTB:
(13.5)
xY   Y 
 YTB
mY  
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Competitiveness and the Trade
Balance
• The effect of the real exchange rate on the level of income
when the trade balance is in equilibrium will depend on the
relative strengths of the competitiveness and terms of trade
effects.
• The substitution effect is thought to dominate when the
Marshall Lerner condition holds, that is, the price
elasticity of exports and imports sum to greater than 1.
• Providing the Marshall Lerner condition is satisfied, an
improvement in competitiveness enables the trade balance
to remain in equilibrium at higher levels of domestic
income.
• Therefore, the BT curve will slope upwards.
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BT curve
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Aggregate Demand and
Competitiveness
• Total planned expenditures equals of the sum of
consumption (C), investment (I), government spending (G),
and net exports (X-M), so the AD curve can be written as:
YAD  C  I  G  X  M
• Consumption is a function of autonomous consumption (a),
the marginal propensity to consume (c), and personal
disposable income (Y-T), where T is the level of lump sum
taxes:
C  a  cY  T 
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Aggregate Demand and
Competitiveness
• Investment is a function of autonomous factors (), such as
expectations, taxes, credit restrictions, etc., and a negative
function of the interest rate (r):
I
0
I  I , r
r
• Government spending and lump sum taxes are exogenously
determined: G  G
T T


• And, net exports are calculated as the trade balance:
X  M  xY   Y   mY  Y
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Aggregate Demand and
Competitiveness
• Substituting theses components into the AD
schedule gives:
Y  a  cY  T   I , r   G  xY  Y   mY  Y
• This can be rearranged by collecting terms in
Y: Y  a  I , r   G  cT  xY  Y   c  mY  Y
• And, simplified by moving the Y terms to
the left-hand side,


YAD 
a  I , r   G  cT  xY   Y 
1  c  m  
Y
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AD Schedule
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Aggregate Demand and
Competitiveness
• This is not surprising because the AD schedule incorporates
the trade balance, which is also an upward sloping schedule.
• As long as the Marshall Lerner condition holds, then a real
depreciation will increase net exports and aggregate
demand.
• There are many things that may shift the AD schedule. In
fact, anything that leads to a change in any of the
parameters in other than θ will lead to a shift in the
schedule. For example, if government spending were to
rise, then aggregate demand would be higher at every level
of θ, so the AD schedule will shift horizontally to the right.
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Rise in Government Spending
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Why is the BT schedule flatter than
the AD schedule?
• The reason is the same as why the BT schedule will shift
further than the ISXM schedule following a change in the
exchange rate.
• From (13.5), the relationship between the real exchange rate
and YTB is:
x  Y 
YTB 
Y
mY  
• The relationship between the real exchange rate and YAD is:
YAD 
xY   Y 
1  c  m  
Y
• As long as one minus the marginal propensity to consume is
greater than zero, then the AD schedule will be steeper than
the BT schedule.
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Real depreciation
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The NAIRU and Long Run Aggregate
Supply in the Open Economy
•
In a closed economy, the NAIRU
and the associated long run
aggregate supply curve, were
determined by a bargaining
equilibrium in the labour market.
•
The PRW curve is derived from a
firm’s price-setting relationship and
describes how the price level is
determined in the economy. In a
closed economy, this was simply a
mark up over marginal costs. This
can be considered as the price of
domestic output:
•
Rearranged to give the PRW:
W
PD  1   
LP
W
LP
PRW : w  
P 1   
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The NAIRU and Long Run Aggregate
Supply in the Open Economy
• In an open economy, the domestic price level, though, will not be solely
determined by the price of domestic goods; it will also consist of the
price of goods imported from overseas. The price of imported goods
will be determined by the foreign price level and the nominal exchange
rate (E):
P  EP
M
• The overall price level P is then a weighted combination of domestic PD
and imported prices PM, where the respective weights reflect the
proportion of domestic and foreign goods sold in the home market:
P  PD  1   PM
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The NAIRU and Long Run Aggregate
Supply in the Open Economy
• It is clear from that in an open economy the domestic price
level will be affected by overseas factors. By altering the
price of imported goods, changes in the overseas price level
or the nominal exchange rate can feed directly into the
domestic price level:
W


P    1   
  1    EP

LP 
• The same factors will determine the NAIRU and long run
aggregate supply.
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The NAIRU and Long Run Aggregate
Supply in the Open Economy
• The open economy version
of the PRW schedule is as
follows.
• Substitute in for the real
W 
EP 

exchange rate:
1    1   
  1   


LP  P 
P
EP

•
Rearrange:
P
 1    W 
  1   
1   
 LP P 
W 1  1     LP 


PRW : w  
P

 1    
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The NAIRU and Long Run Aggregate
Supply in the Open Economy
• The open economy price determined real wage (PRW) is the
same as the closed economy if we set =1. However, as long
as <1, foreign goods will constitute a positive proportion of
the price level.
• The price level will be determined by the real exchange rate,
and in particular, the nominal exchange rate and overseas price
level. Changes in the real exchange rate will then change
domestic prices and the price-determined real wage.
• The bargained real wage (BRW) can then be represented in the
following way:
W
BRW :
P
 Z  u
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Open economy PRW
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The NAIRU and Long Run Aggregate
Supply in the Open Economy
• The Non-Accelerating Inflation Rate of
Unemployment (NAIRU) is determined by the
intersection of the price setting and wage setting
schedules.
• In the open economy, though, we will see that there
is no longer a unique NAIRU. The NAIRU will be
different depending on the level of the real
exchange rate.
• As the real exchange rate appreciates, the NAIRU
falls – meaning that non-accelerating inflation is
sustainable at a lower rate of unemployment.
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NAIRU in the Open Economy
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NAIRU in the Open Economy
• In an open economy, though, an appreciated exchange rate
would give the economy an inflationary subsidy. Falling
import prices would put downward pressure on the overall
price level. If unemployment were then to fall, this would
put upward pressure on domestic prices, but this would be
offset by the fall in import prices –leaving the overall price
level unchanged.
• It can, therefore, be seen that an exchange rate appreciation
enables the economy to move to a lower level of
unemployment whilst maintaining price stability. A
depreciation, of course, would have the opposite effect.
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The NAIRU and Long Run Aggregate
Supply in the Open Economy
• The relationship between the NAIRU and the equilibrium level of
output is determined in a number of steps.
• Output is simply a function of employment (N): Y=F(N).
• The total labour force (L) consists of the total number of employed (N)
and unemployed persons (U): L=N+U.
• Dividing both sides by L enables us to see that the relative proportions
of employed and unemployed workers in the economy add up to one:
• The unemployment rate is:
1
N
u
L
u
U
L
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The NAIRU and Long Run Aggregate
Supply in the Open Economy
• Rearranging this, we can then express employment as a
function of unemployment, i.e., employment is equal to the
proportion of the labour force that is not unemployed:
N  L1  u 
• If unemployment is at the NAIRU, then the long run
aggregate supply level of output will be defined as:
Yˆ  F L1  uˆ 
• There is an inverse relationship between the equilibrium
level of output and the NAIRU. In an open economy, the
long run aggregate supply curve is referred to as the
Competing Claims Equilibrium (CCE). As the exchange
rate appreciates, the equilibrium level of output (where
inflation is constant) will rise.
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Competing Claims Equilibrium (CCE)
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The NAIRU and Long Run Aggregate
Supply in the Open Economy
• The slope of the CCE schedule depends on the size of the
shifts in the PRW curve for a given change in
competitiveness.
• This is largely determined by the parameter . If =1, then
the foreign price effect on the PRW curve would disappear
completely, as imports constitute no part of the domestic
price level. The NAIRU and the equilibrium level of output
will once again be uniquely determined.
• The CCE schedule would be similar to its closed economy
counterpart, vertical at the equilibrium level of output.
• As 0, foreign goods are an increasing proportion of the
domestic price level. As competitiveness falls, higher levels
of output can be sustained without prices rising, so the CCE
curve becomes flatter.
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The trade balance and the
sustainable level of output
• In the closed economy, the long run aggregate supply curve
represents a constraint on the path of the economy. Any
position away from this will lead to a change in prices that
pushes the economy back onto the long run aggregate
supply curve.
• In an open economy, though, the Competing Claims
Equilibrium (CCE) schedule suggests there is a range of
output where inflation is constant, depending on the real
exchange rate.
• Although any point on the CCE schedule is consistent with
stable prices, will a deficit on the balance of trade act as a
constraint preventing the economy from remaining at a
higher level of output such as Y1?
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Trade deficit
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The trade balance and the
sustainable level of output
• If a deficit remains for a long period of time, the mounting
interest rate payments place increasing pressure on the
economy as the flow of interest payments overseas
increases, which will require more offsetting capital
inflows.
• In the long run, the trade balance could well exert a
constraint on the economy. The solution would be to let the
exchange rate depreciate and improve competitiveness, but
this will lead to a movement along the CCE schedule,
increasing the NAIRU.
• The sustainable level of output is where the CCE and BT
curves intersect at YS. This is regarded as a long run point,
where the economy is at its NAIRU, and the balance of
trade is in equilibrium.
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Equilibrium in the Salter-Swan model
• Equilibrium in the open economy is where the AD, CCE
and BT schedules intersect.
• This represents a position where the goods market is in
equilibrium, output is at a level where unemployment is at
the NAIRU, and the trade balance is in equilibrium.
• In the short run, the economy will be on the AD schedule,
where planned expenditures are equal to actual income.
• A position on the competing claims equilibrium (CCE) can
be thought of as a long run equilibrium point for the
economy. In the short run, the economy can move off this
schedule, but in the long run a movement in prices would be
sufficient to push the economy back towards this schedule.
If prices adjust slowly, then this might take some time.
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Equilibrium in the Salter-Swan model
• In the very long run, the economy will also need to
maintain balance of trade equilibrium. If the
economy is running a surplus or a deficit for a
sustained period of time, it will either accumulate
an increasing number of assets or liabilities,
respectively, which are ultimately unsustainable.
Therefore, the economy should end up on a
position on the BT schedule.
• Therefore, the long run equilibrium of the economy
is the sustainable level of output, YS.
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Equilibrium in the Salter-Swan model
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Fiscal expansion
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Shift in the CCE
• Any policy that leads to an
upward shift in the PRW
schedule other than an
exchange rate appreciation,
or an inward shift in the
BRW, would achieve a
lower NAIRU.
• Long run aggregate supply
would therefore be greater
at every exchange rate.
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Shifting the BT Schedule
• Any factor other than a
change in the real
exchange rate – which
leads to either a rise in
exports or a fall in
imports – will shift the
BT Schedule.
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Shifting the CCE and the BT
Schedules
• An increase in the sustainable level of output will
result if both curves shift accordingly.
• It could certainly be the case that policies aimed
at shifting one curve could shift the other.
• For example, government spending on education
and training may improve labour productivity
(CCE shifts right), but also lead to the
development of better designed products that are
more competitive in world markets (BT shifts
right).
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Increase in the sustainable level of
output
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Global Applications 13.3
• Narrowing the U.S.
Current Account
Deficit
• Current level (point a)
and sustainable level
(point b) of output in
the U.S. economy.
• How can this be
addressed?
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Summary
• The AD-CCE-BT or Salter-Swan model is the open
economy version of the traditional aggregate demand and
supply (AD-AS) model.
• The Aggregate demand (AD) curve reflects equilibrium in
the goods market. The Competing Claims Equilibrium
represents the long run aggregate supply curve consistent
with the NAIRU, and the BT schedule where the trade
balance is in equilibrium.
• In an open economy, the domestic price level will consist of
goods and services imported from overseas. Therefore,
foreign goods prices and changes in the nominal exchange
rate can pass through into the domestic price level.
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Summary
• In an open economy, the NAIRU is not unique but depends
on the prevailing real exchange rate. A real exchange rate
appreciation lowers the cost of foreign goods and puts
downward pressure on the domestic exchange rate. This
enables a lower rate of domestic unemployment to be
achieved whilst maintaining overall price stability.
• The trade balance forms a long run constraint on the level
of output. The sustainable level of output is where the BT
and CCE schedules intersect. Maintaining a target level of
income requires either a shift in the CCE, BT or both
schedules.
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