Output & the Exchange Rate
in the Short Run
• Two kinds of depreciations
Britain
East Asian countries
92 depreciation
97 depreciation
export surged
recession+inflation
???
???
output, exchange rate,
and inflation
to understand
Output & exchange rate in the
short run
•
1.
2.
3.
4.
Aggregate demand for an open economy’s
output is the sum of:
consumption demand (C)
investment demand (I)
government demand (G)
net export demand / current account (CA)
Real exchange rate
changes →CA
• the effect of a real exchange rate change on
the current account CA is ambiguous.
• other things equal, a real depreciation of
the currency improves the current account.
Disposable income
changes →CA
• an increase in disposable income worsens
the current account.
The equation of aggregate demand
D  D( EP * / P, Y  T , I , G )
实际汇率
消费
投资， 政府采购
Y  D( EP * / P, Y  T , I , G )
Real output (Y) = Aggregate demand (D)
2 elements
1: relationship between output & exchange
rate (the DD schedule) that must hold when
the output market is in equilibrium
2: relationship between output & exchange
rate that must hold when the home
money market & the exchange market
(the asset market) are in equilibrium
Aggregate demand, D
D=Y
Aggregate demand
D( EP * / P, Y  T , I , G )
Output↑→demand↑
Output, Y
Fig 16-1, Aggregate Demand as a Function of Output
Output market equilibrium in
the short run: the DD schedule
DD = relationship between output &
exchange rate
Aggregate demand, D
D=Y
Aggregate demand
贬值
产出增加
Output, Y
Fig 16-3, Output effect of a currency depreciation with …
Deriving the DD schedule
• When P and P* are fixed, a depreciation of the
currency leads to the higher output level.
• DD: all combinations of output & exchange
rate
• output market is in short-run equilibrium
• aggregate demand = aggregate output
D
Output market
in Equilibrium
Exchange Rate E
DD
Y
贬值
产出增加
Output
Y
Factors that shift the DD schedule
1. government demand, taxes, & investment
2. domestic & foreign price levels
DD
3. variations in domestic consumption
behavior
4. foreign demand for home output
D( EP * / P, Y  T , I , G )
增加政府开支，国际收支赤字
D
①
政府搞赤字财政
DD
Exchange Rate E
②
贬值
DD
③
产出增加
Y
Output
Y
D( EP * / P, Y  T , I , G )
1.
2.
3.
4.
5.
6.
7.
A change in G.
A change in T.
A change in I
d
A change in P
Y E
A change in P*
A change in the consumption function
A demand shift between foreign & domestic
goods.
• Any disturbance that raises aggregate
demand for domestic output shifts the DD
schedule to the right;
• Any disturbance that lowers aggregate
demand for domestic output shifts the DD
to the left.
Asset market equilibrium in
the short run: the AA schedule
• AA: equilibrium in the domestic
money market & foreign exchange
market.
• foreign interest rate is taken as given
R  R * ( E  E ) / E
e
M / P  L( R, Y )
s
…The changes in the exchange rate must
accompany output changes so that asset
markets remain in equilibrium.
Exchange
market
E
Ee & R* fixed
●
②本币升值
●
外汇存款本
币的收益
Asset market
equilibrium
R
L ( R, Y )
①产出增加
Money market
●
Ms
P
●
Ms
P
upshot
• For asset markets to remain in equilibrium:
• a rise in domestic output must be
accompanied by an appreciation of the
domestic currency, and vice versa.
• 本币升值=本币存款利息上升？
Deriving the AA Schedule
Exchange Rate
E
与DD线最大不同：先产出，
后升值
②本币利率上升
③本币升值
AA
①产出增加→
Y
Output
AA schedule
• It relates exchange rates and output levels
that keep the money and foreign
exchange markets in equilibrium.
Factors that shift the AA schedule
R  R *  ( E  E ) / E M / P  L ( R, Y )
e
1.
2.
3.
4.
5.
s
A change in Ms . (positive correlate)
A change in P. (negative correlate)
A change in Ee. (positive correlate)
A change in R*. (positive correlate)
A change in real money demand L(R, Y).
(negatively correlate)
short-run equilibrium for an
open economy: DD + AA
• Assumption: output price temporarily fixed
foreign interest rate R* fixed
expected future exchange Ee fixed.
One-short changes→money supplies
temporary policy→no effect→Ee
Short-run equilibrium: intersections of
DD and AA
E
DD 调整慢
产出市场
调整快
AA
资产市场
Y
saddle point
DD
E
①
预期升值压力
②
产出市场
贬值打破均衡
③
AA
增产速度缓慢
资产市场
Y
Temporary changes in monetary &
fiscal policy
government macroeconomic policy
output
employment
inflation
counteracting
disturbances
Monetary Policy
①货币供给增加
②本币贬值
③产出增加
④远期汇率不变
⑤短期效应
E
DD
②
③
AA
Y
Fiscal Policy
①政府开支增或
减少税收
②提高总需求
③产出增加
④远期汇率不变
⑤短期效应
E
DD
后本币升
值
AA
③先产出增加
Y
Policies to maintain full employment
贬值扩大出口带动Output
monetary policy
产出增加=就业增加？
Fiscal policy
扩大需求刺激产出Output
充
分
就
业
外需突然减少后如何维持充分就业？
fall in world demand→②
E
DD
③
monetary policy
The two policies differ
in their exchange rate
effects:
②
①
AA
fiscal policy
●
Y
●充分就业时的产出水平
Inflation Bias
1. macroeconomic policy→inflation bias:
election→temptation→expansion, boom,
wage demand↑→spiral →central bank
independent.
2. disturbance →output market? or asset market?
hard to choose monetary or fiscal policy.
3. fiscal policy →lengthy legislative deliberation;
monetary policy →inflation.
4. budget deficit→not to synchronize →business
cycle, election cycles.
5. lags of varying length →how much of monetary
or fiscal medicine to administrate.
Permanent shifts in monetary &fiscal policy
Government policy instruments:
money supply
government spending
taxes
long-run exchange rates
Initial conditions or assumptions:
a full employment
exchange rate at long-run level
domestic interest = foreign interest
A permanent increase in the Money Supply
upshot:
A permanent increase in Money Supply
must ultimately lead to a proportional rise in
Exchange Rate.
Ms = Ee
Adjustment to
s
M↑
• Assumption: full employment, working
overtime.
• Ms has no lasting effect on output,
relative prices, interest rate
• overshooting phenomenon will return to its
full employment position.
E
DD
AA
●
充分就业水平
Y
A permanent fiscal expansion
• Government expenditure→aggregate demand
for domestic goods and services;
• long-run appreciation of currency;
• fall of the expected future exchange rate;
E
DD
本币升值
停留在此
AA
●
充分就业水平
Y
Conclusion
• If the economy starts at long-run equilibrium,
a permanent change in fiscal policy has no
net effect on output. Instead, it causes
an immediate and permanent exchange rate
jump that offsets exactly the fiscal
policy’s direct effect on aggregate demand.
Macroeconomic policies &
current account
• Monetary & fiscal policies aimed at
domestic objectives > current account.
• DD—AA model can be extended
to…current account.
• DD—AA—XX model: combinations of the
exchange rate and output at which the
current account balance would be equal to
some desired level.
XX curve
CA( EP * / P, Y  T )  X
XX is flatter than DD
CA balance fall after fiscal expansions.
E
CA=X
DD
monetary
expansion
XX
temporary
fiscal
expansion
permanent
fiscal
expansion
CA>X
CA<X
AA
Y
monetary expansion causes the current account balance to
increase in the short run.
temporary fiscal expansion: There is a deterioration in the
current account because the currency appreciates and
income rises.
permanent fiscal expansion: Expansionary fiscal policy
reduces the current account balance.
DD-AA model: a real depreciation of the home currency
immediately improves the current account while a real
appreciation causes the current account immediately to
worsen.
• …the domestic demand for domestic output
rises by less than the rise in output itself
(since some income is saved and
spending falls on imports)
• Depreciation of currency along DD to
make export demand rise faster than import
Gradual trade flow adjustment &
current account dynamics
The J-Curve （中文展开）
If the current account initially worsens after a
depreciation, its time path, has an initial
segment reminiscent of a J.
The primary effect of the depreciation is to raise
the value of the pre-contracted level of
imports in terms of domestic products.
These lags in adjustment …,
After the current account exceed its predepreciation level …,
Increase in CA tapers off as the adjustments to
the real depreciation is completed.
If expansionary monetary policy depresses
output in the short run, the
domestic interest rate will fall farther than it
normally would.
Exchange rate pass-through &
inflation
• Assumption: Nominal output prices P & P* can
not suddenly jump…
• Nominal exchange rate movements affect
current account in the short run.
•
Linkage between the nominal
exchange rate and prices of exports
and imports.
Pass-through
The percentage by which import prices
rise when the home currency depreciates
by one percent is known as the degree of
pass-through from the exchange rate to
import prices.
Percentage???
e.g. DD-AA model: degree is 1. = any
exchange rate changes is passed through
completely to import prices.
Why incomplete?
1. International market segmentation
imperfectly competitive firms charge different
prices for the same product in different
countries.
2. Firms wait to find out the currency movement
reflects a definite trend before making price
and production commitments
3. Timing of current account adjustment:
4. Currency movements have less-thanproportional effects on the relative price
determining trade volumes
Korea’s Trade Balance
with the U.S. and the
Won/Dollar exchange rate
depreciation+income cut
Skip over Page 474-480
Marshall-Lerner Condition
• The validity of the assumption: a real
depreciation of a country’s currency
improves its current account.
• Derive a condition on those responses.
• The Marshall-Lerner condition: all else
equal, a real depreciation improves the
current account if export and import
volumes are sufficiently elastic with
respect to exchange rate.
CA( EP / P, Y d )  EX ( EP / P)  IM ( EP / P, Y d )

q  EP / P
Foreign income is being held constant.
IM  q  EX
Imports measured in
domestic output

Imports measured in
foreign output unit

CA(q, Y )  EX (q)  q  EX (q, Y )
d
d
EX
EX q 
q
EX
EX 
q

q
q  q  q
2
贬值幅度
1
+
the effect of a rise in q (a real
depreciation) on export demand
–
the effect of a rise in q (a real
depreciation) on import volume

a real exchange rate changes
from time 1 to time 2
CA  CA  CA
2
1
2
1
 ( EX  q  EX )  ( EX  q  EX )
2
2
1

1
1
 EX  (q  EX )  (q  EX )
2
Dividing through by △q gives the CA response to a change in q,
<0
>0
2

1
q
q
CA / q  EX  (q  EX )  EX
Volume effect
value effect
volume effect vs. value effect
• Volume effect: the effect of change in q on the
number of output unit exported and imported.
• Value effect: a rise in q worsens the current
account to the extent that it raises the domestic
output value of the initial volume of imports.
Elasticity
  (q / EX ) EX q
1
1
elasticity of export demand
  (q / EX ) EX

1
1
 elasticity of import demand
q

q
CA / q  EX q  (q  EX )  EX
2
multiply its right-hand side by
of trade elasticities.
1
1
(q / EX )
1
to express it in term
CA initially 0  EX  q  EX
1
CA / q  0;
1
1
  (q / q )  1  0
2
1

If q  0; then, q 2  q1
the condition for an increase in q to improve the current account is
   1

   1

   1

It the current account is initially zero, a real
currency depreciation causes a current
account surplus if the sum of the relative price
elasticities of export and import demand
exceeds 1.
Complexity & Conclusion
• current account initially is non zero;
• disposable income is held constant when q
changes;
• Conclusion of empirical study:

• Most countries,     1
• In the long run, a real depreciation improve the
current account.