Aggregate Demand,
International Trade
and Exchange Rates
Revised Oct 17, 2006
• We know from macro that a country's net
exports, (X -IM), are one component of its
aggregate demand, C + I + G + (X -IM).
• Thus, an autonomous increase in exports or
decrease in imports has a multiplier effect
on the economy, just like an increase in C, I,
or G.
• This conclusion is shown on an aggregate
demand and supply diagram. A rise in net
exports shifts the aggregate demand curve
outward to the right, changing the
equilibrium from point A to point B. Both
GDP and the price level rise.
Price
Aggregate Demand and Supply
Diagram
S1
Level
A
P1
D1
Q1
Real GDP
Price
Aggregate Demand and Supply
Diagram
S1
Level
B
P2
P1
A
D2
D1
Q1
Q2
Real GDP
What increases net exports?
• a rise in foreign incomes
Booms or recessions in one country tend to
be transmitted to other countries through
international trade in goods and services.
• the relative prices of foreign and domestic
goods
law of demand. If the prices of the goods of
Country X rise, people everywhere will tend to
buy fewer of them--and more of the goods of
Country Y.
• A fall in the relative prices of a country's
exports tends to increase that country's
net exports and hence to raise its real
GDP.
• A rise in the relative prices of a country's
exports will decrease that country's net
exports and GDP.
Relative Prices, Exports, and
Imports
• Assume -- just for this short section -- that
exchange rates are fixed.
• What happens if the prices of American
goods fall while, say, Japanese prices are
constant?
• With U.S. products now less expensive
relative to Japanese products, both Japanese
and American consumers will buy more
American goods and fewer Japanese goods.
• As a result, America's exports will rise and
its imports will fall, adding to aggregate
demand in the U.S.
• A rise in American prices (relative to
Japanese prices) will decrease U.S. net
exports and aggregate demand.
Thus:
• A fall in the relative prices of a country's
exports tends to increase that country's
net exports and hence to raise its real
GDP.
• A rise in the relative prices of a country's
exports will decrease that country's net
exports and GDP.
The Effects of Changes in
Exchange Rates
• How do changes in exchange rates affect a
country's net exports since currency
appreciations or depreciations change
international relative prices?
(Remember: the basic role of an exchange
rate is to convert one country’s prices into
another country’s currency.)
Exchange Rates and Home Currency
Prices
30,000
Yen
TV Set
$1,000
US
Home PC
Price in
The US
Price in
The US
Price in
Japan
$1 = 120 30,000 Y $250
yen
$/Y=.0083
$1,000
120,000 Y
$1 = 100 30,000 Y $300
yen $/Y=.01
$1,000
100,000 Y
Exchange Price in
Rate
Japan
• From the American consumer’s
viewpoint, a television set that costs 30,000
yen in Japan goes up in price from $250
(that is, 30,000/120) to $300 (that is,
30,000/100).
• To Americans, it is just as if Japanese
manufacturers had raised TV prices by 20
percent.
• The Dollar price of the yen went from $0.0083 to
$0.01 – an appreciation of the yen.
• What about the implications for Japanese
consumers interested in buying American
personal computers that cost $1,000?
• When the dollar falls from 120 yen to 100
yen, they see the price of these computers
falling from 120,000 yen to 100,000 yen.
• To them it is just as if American producers
had offered a 16.7 percent drop in the price
of PCs.
• A currency depreciation should raise net
exports and increase aggregate demand.
• A currency appreciation should reduce
net exports and therefore decrease
aggregate demand.
• In this case the U.S. dollar has
depreciated. Thus, U.S. exports should
rise.
Depreciation
P
AS1
B
A
P1
AD2
AD1
Q1
GDP
Appreciation
P
AS1
A
P1
AD1
AD2
Q1
GDP
Conclusions to date:
  currency depreciations increase AD.
  currency appreciations decrease AD.
Aggregate Supply in an Open Economy
• To complete the model of macroeconomics
in an open economy, let’s look at the
implications of international trade for
aggregate supply.
• The United States, like all economies, buys
some of its productive inputs from abroad.
• When the dollar depreciates, the prices of
imported inputs rise.
• The U.S. aggregate supply curve
therefore shifts inward, pushing up the
prices of U.S. made goods and services.
• Conversely, an appreciation of the
currency makes imports cheaper and
shifts the U.S. aggregate supply curve
outward thus pushing prices down.
Depreciation
P
AS2
AS1
GDP
Appreciation
P
AS1
AS2
GDP
Macro economic effects of
exchange rates
• Let’s put aggregate demand and aggregate
supply together and work through the
macroeconomic effects of changes in
exchange rates.
• Suppose the international value of the dollar
falls (i.e. it depreciates).
• What happens to AD?
• What happens to AS?
A currency depreciation is inflationary
and probably also expansionary.
• When the dollar falls, foreign goods become
more expensive to Americans. That effect
is directly inflationary. AS shifts leftward.
• At the same time, aggregate demand in the
U.S. is stimulated by rising net exports. AD
shifts to the right.
• As long as the expansion of demand
outweighs the adverse shift of the aggregate
supply curve brought on by currency
depreciation, real GDP should rise.
Depreciation
P
AS2
AS1
P2
A
P1
AD2
AD1
Q1
Q2
GDP
• Qualification: Countries that borrow in foreign
currency will see their debts increase whenever
their currencies fall in value.
• For example, an Indonesian business that
borrowed $1,000 in July 1997, when $1 was worth
2,500 rupiah, thought it owed 2.5 million rupiah.
• But when the dollar suddenly became worth
10,000 rupiah, the company owed 10 million
rupiah. Many businesses found themselves unable
to cope with their crushing debt burdens and
simply went bankrupt.
• Reverse direction. What happens when the
currency appreciates.
• In this case, net exports fall so the aggregate
demand curve shifts to the left. At the same
time, imported, inputs become cheaper, so the
aggregate supply curve shifts outward.
• Both of these shifts are shown in the Figure.
Once again, as the diagram shows, we can be
sure of the movement of the price level: It falls.
• Output also falls if the demand shift is larger
than the supply shift, as is likely. Thus:
Appreciation
P
AS1
AS2
A
P1
P2
AD1
AD2
Q2 Q1
GDP
• A currency appreciation is
disinflationary and probably also
contractionary.
• This analysis explains why many
economists and financial experts cringe
whenever the Japanese yen appreciates.
• If Japan is already experiencing both
deflation and recession. The last thing they
need, economists argue, is a decrease in
aggregate demand and further deflation.
To date, we have analyzed
international trade in goods and
services, but have ignored
international movements of
capital.
• For some nations, this omission is
inconsequential because they rarely receive
or lend international capital.
• But things are quite different for the United
States because the vast majority of
international financial flows involve buying
or selling assets whose values are stated in
U.S. dollars.
• In addition, we cannot hope to understand
the origins of the various international
financial crises without incorporating
capital flows into the analysis.
• Recall that interest rate differentials and
capital flows are important determinants of
exchange rate movements.
• Suppose interest rates in the United States
rise while foreign interest rates remain
unchanged.
• We have learned that this change in relative
interest rates will attract capital to the U.S.
and cause the dollar to appreciate.
• We just showed that an appreciating dollar
will, in turn, reduce net exports, prices, and
output in the United States Thus:
• A rise in interest rates tends to contract
the economy by appreciating the
currency and reducing net exports.
• You learned in macro principles when you studied
monetary policy that higher interest rates tend to
reduce investment spending and hence reduce the
I component of C + I + G + (X- IM).
• In an open economy with international capital
flows, we showed that higher interest rates also
reduce the X - IM component.
• Conclusion: International capital flows
strengthen the negative effects of interest rate rises
on aggregate demand.
If interest rates fall in the United States,
or rise abroad, everything we have just
said is turned in the opposite direction.
The conclusion is:
• A decline in interest rates tends to expand
the economy by depreciating the
currency and raising net exports.
Fiscal and Monetary
Policies in an Open
Economy
We need to remember what we have learned
in the discussion up to this point.
Specifically:
• A rise in the domestic interest rates leads to
capital inflows and makes the exchange rate
appreciate. A currency appreciation reduces
aggregate demand and raises aggregate
supply.
• A fall in domestic interest rates leads to
capital outflows and causes an exchange
rate depreciation. A currency depreciation
raises aggregate demand and reduces
aggregate supply.
Fiscal Policy Revisited
Suppose the U.S. government cuts taxes or
raises spending.
P
Closed Economy: Government
Cuts Taxes or Raises G
S0
B
P2
A
P1
D1
D0
Q1
Q2
GDP
• Aggregate demand increases, which pushes
up both real GDP and the price level in the
usual manner.
• This effect is shown as the shift from Do to
the D1 in the figure. In a closed economy,
that single shift is the end of the story.
• But in an open economy with international
capital flows, we must add in the
macroeconomic effects that work through
the exchange rate.
• We do this by answering two questions.
1. What will happen to the
exchange rate?
• Fiscal expansion pushes up interest rates.
• At higher interest rates, U.S. securities
become more attractive to foreign investors,
who go to the foreign exchange markets to
buy dollars with which to purchase the
securities.
• This buying pressure drives up the value of
the dollar. Thus:
A fiscal expansion normally makes
the exchange rate appreciate.
2. What are the effects of a
higher dollar?
• We know that when the dollar rises in value,
U.S. goods become more expensive abroad
and foreign goods become cheaper here in
the U.S.
• So exports fall and imports rise, driving
down the X - IM component of aggregate
demand.
• The fiscal expansion thus winds up
increasing America's capital account
surplus (by attracting foreign capital) and
its current account deficit (by reducing net
exports).
• In fact, the two must rise by equal amounts
because, under floating exchange rates, it is
always true that:
Current account surplus + Capital account
surplus = 0
Note: the induced rise in the dollar
will shift
 the aggregate supply curve outward.
 the aggregate demand curve inward.
 The final equilibrium in an open economy is
point C, whereas in a closed economy it
would be point B. By comparing points B
and C, we can see how international
linkages change the picture of fiscal policy
associated with a closed economy.
P
Open Economy-Government Cuts
Taxes or Raises G
S0
B
S2
A
P1
C
D1
D2
D0
Q1
Real GDP
Two main differences arise.
• First, a higher exchange rate makes imports
cheaper and thereby offsets part of the
inflationary effect of a fiscal expansion.
• Second, a higher exchange rate reduces the
expansionary effect on real GDP by
reducing X- IM.
• In a closed economy we learned that an
increase in G will crowd out some private
investment spending by raising interest
rates.
• In an open economy, an increase in G, by
raising both interest rates and the exchange
rate, crowds out net exports.
• But the effect is the same: The fiscal
multiplier is reduced. Thus, we conclude
that:
International capital flows
reduce the power of fiscal policy.
Monetary Policy Revisited (i.e.
in an open economy)
• consider a tightening, rather than a
loosening, of monetary policy.
• contractionary monetary policy reduces
aggregate demand, which lowers both real
GDP and prices. (shift from Do to D1, and it
looks like the exact opposite of a fiscal
expansion. Without international capital
flows, that would be the end of the story. )
P
Contractionary Monetary Policy
without International Capital Flows
S0
A
P0
P1
B
D0
D1
Q1
Q0
Real GDP
• But in the presence of internationally mobile
capital, we need to work through the impacts on
interest rates and exchange rates.
• As we know from Ec152, a monetary contraction
raises interest rates just like a fiscal expansion.
• Hence, tighter money attracts foreign capital into
the United States in search of higher rates of
return. The exchange rate therefore rises.
• The appreciating dollar encourages imports and
discourages exports; so X - IM falls. The U.S.
therefore winds up with an inflow of capital and
an increase in its trade deficit.
• In the figure the two effects of the exchange
rate appreciation are that: aggregate supply
shifts outward So to S2 and aggregate
demand shifts inward. This time, as you can
see in the figure:
P
Contractionary Monetary Policy
with International Capital Flows
S0
A
P0
P1
S2
B
C
D0
D1
D2
Q1
Q0
Real GDP
International capital flows
increase the power of monetary
policy.
INTERNATIONAL ASPECTS OF
DEFICIT REDUCTION
Summary of effects of fiscal policy in an open
economy:
• G up or T down => AD rises => interest rates rise
=> dollar appreciation => imports up and exports
down => AD falls
(Thus, the initial AD rise is not as large as in a
closed economy.)
• G down or T up => AD falls => interest rates fall
=> dollar depreciation => imports down and
exports up => AD rises
(Thus, the initial drop in AD is not as large as in a
closed economy.)
Summary of effects of Monetary policy in an open
economy:
• Tightening monetary policy => interest rate rises
=> I falls (AD falls) => dollar appreciation =>
imports up and exports down => AD falls
(Thus, the initial AD decrease is larger compared
to a closed economy.)
• Expansionary monetary policy => interest rate
falls => I rises (AD rises) => dollar depreciation
=> imports down and exports up => AD rises
(Thus, the initial AD increase is larger compared
to a closed economy.)
• Now let us put the open economy theory to
work by applying it to the events of the
1990s when fiscal policy was tightened and
monetary policy was eased. Should
reducing the budget deficit (or raising the
surplus) strengthen or weaken the dollar?
• The U.S. government transformed its huge
budget deficit into a notable surplus during
the 1990s by raising taxes and cutting
expenditures.
• This should lower the real interest rate,
make the dollar depreciate, reduce real
GDP, and be less disinflationary than
normal because of the falling dollar.
• But the Fed practiced expansionary policy
and lowered interest rates. This should lead
to a depreciation of the dollar and an
increase in real GDP and Inflation.
Expected Effects of Policy
Fiscal
Variable Contraction
Real interest
rate
Exchange
rate
Net exports
+
Real GDP
Inflation
-
Monetary
Expansion
Net
Effect
-
-
+
+
+
+
?
?
Results in the 1990s
1.
2.
3.
4.
Interest rates fell.
The U.S. economy expanded.
Inflation fell.
Exchange rate fell in 93 – 95; but rose
thereafter in the nineties.
5. Net exports went from -20 billion in 1992
to -$221 in 1998.
(4 and 5 were not consistent with projections)
Expected Effects of Policy in 2002 2003
Fiscal
Variable Expansion
Real interest
rate
+
Exchange
rate
+
Net exports
Real GDP
+
Inflation
+
Monetary
Expansion
Net
Effect
-
?
+
+
+
?
?
+
+
Link between the Budget Deficit and the Trade
Deficit
GDP:
1. Y = C + I + G + (X – M)
GDP can be consumed, saved or taxed
2. Y = C + S + T
3. C + I + G + (X – M) = C + S + T
Rearranging terms:
4. X – M = (S – I) – (G – T): accounting definition
(Meaning: two sources of a trade deficit)
1. A government budget deficit
2. An excess of investment over saving
Back to the 90’s
1. government deficit (G – T) fell; thus trade
deficit (X – M) should fall– ceteris paribus
2. ceteris paribus does not hold since S – I is
also important. (I boomed but S fell):
(S – I) moved in a negative direction,
causing an increase in the trade deficit .
Expected Effects of Policy in 2004
Variable
Real interest
rate
Exchange
rate
Net exports
Real GDP
Inflation
Fiscal
Expansion
Monetary
Contraction
Net
Effect
+
+
+
+
+
+
+
-
+
?
?
Historically, trade deficit has
been a problem
• Economy as a whole -- the government and
the private sector -- are consuming more
than they are producing.
• Upshot: U.S. must borrow the difference
from foreigners.
• The deficit simply mirrors the required
capital inflows from foreigners.
Two possible interpretations:
1. Capital inflows create debts requiring future
interest and principal payments.
(Future generations will have to pay the debt.)
2. US is an attractive place to invest capital.
Investors want to invest (lend) to the US. This
will tend toward a higher dollar and also the
tendency will be to reduce net exports. In this
case though, this should be viewed as a strength,
not a weakness.
Reducing the Trade Deficit
• Tighten Fiscal Policy and loosen monetary
policy.
• Other countries need to grow faster.
• Raise domestic saving or reduce domestic
investment.
• Raise tariffs and quotas as a form of
protectionism