Section 5
The Exchange Rate in the Short Run
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Content
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Objectives
Aggregate Demand
Output Market Equilibrium
Asset Market Equilibrium
The Short-Run Equilibrium
Temporary Policy Changes
Permanent Policy Changes
The J-Curve
Summary
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Objectives
• To understand the determinants of aggregate
demand.
• To know how output is determined using
aggregate demand and aggregate supply.
• To know the effects of fiscal and monetary
policy.
• To know the J-curve
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Aggregate Demand
• Aggregate demand comes from
D  C  I  G  EX  IM
• Aggregate demand is the amount of a country’s
output demanded by throughout the world.
• It consists of
–
–
–
–
Consumption demand (C)
Investment demand (I)
Government demand (G)
Current account (CA)
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Aggregate Demand
• Determinants of Aggregate Demand
– Consumption demand is a positive function of
disposable income (Yd=Y-T):
C  C (Y  T )
• An increase in disposable income raises both
consumption demand and savings, thus:
0  Cyd
C (Y d )

1
d
(Y )
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Aggregate Demand
– Investment demand is assumed to be exogenous
for now. In more complex models, investment
demand is a positive function of income and a
negative function of the interest rate.
– Government demand is a policy variable. It is
assumed exogenous.
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Aggregate Demand
– The current account (CA) is the net foreign
demand for a country’s output
• CA=EX-IM
– The current account depends on the real
exchange rate (Q=SP*/P)and disposable
income(Yd=Y-T):
CA  CA( SP * / P, Y  T )
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Aggregate Demand
• An increase in the real exchange rate raises the price
of foreign baskets of goods, which improves the
current account:
d
CA(Q, Y )
CAQ 
0
Q
• An increase in disposable income raises the demand
for foreign goods, which worsens the current
account:
CA(Q, Y d )
CAy d 
0
d
Y
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Aggregate Demand
• Aggregate demand
D  C (Y  T )  I  G  CA( SP * / P, Y  T )
• Alternatively, aggregate demand is
D  D( SP * / P, Y  T , I , G )
D  D(Q, Y , I , G)
d
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Aggregate Demand
• Aggregate demand is a positive function of the
real exchange rate:
– An increase in the real exchange rate (Q)
improves the current account (CA) and raises
aggregate demand (D):
D(Q, Y d , I , G)
DQ 
0
Q
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Aggregate Demand
• Aggregate demand is a positive function of
disposable income:
– A rise in disposable income stimulates consumption and
worsens the current account, but the overall effect is to
raise aggregate demand:
0  DY d
D(Q, Y d , I , G )

1
d
Y
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Aggregate Demand
• Aggregate demand is a positive function of both
investment and government expenditures:
D(Q, Y d , I , G )
DI 
0
I
D(Q, Y d , I , G)
DG 
0
G
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Aggregate Demand
D
Aggregate Demand
D(Q, Y – T, I, G)
45°
Y
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Output Market Equilibrium
• The output market short-run equilibrium
Y  D( SP * / P, Y  T , I , G )
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Output Market Equilibrium
The Output Market Short-Run Equilibrium
D
D=Y
D(Q,Y-T,I,G)
De
45°
Ye
Y
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Output Market Equilibrium
• The effects of an increase in the real exchange
rate:
– With fixed prices, an increase in the nominal exchange
rate raises the real exchange rate (the relative price of a
foreign basket of goods).
– This causes an upward shift in the aggregate demand
function and an expansion of output.
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Output Market Equilibrium
A depreciation of the home currency
D
D=Y
D(Q2,Y-T,I,G)
D(Q1,Y-T,I,G)
Y
Y
Y
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Output Market Equilibrium
• An increase in either investment or government
expenditures also cause an upward shift in the
aggregate demand function and an expansion of
output.
– The effects are similar to an increase in the
nominal exchange rate.
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Output Market Equilibrium
• The DD schedule
– It shows all the short-run equilibrium
combinations of output and the exchange rate
that are consistent with the output market.
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Output Market Equilibrium
D
The DD Schedule
D=Y
D(S2P*/P, Y-T, G, I)
D(S1P*/P,Y-T,G,I)
S
Y1
Y2
Y
DD
S2
S1
Y1
Y2
Y
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Output Market Equilibrium
• Factors that affect the DD schedule
– A change in the nominal exchange rate or of output is a move
along the DD schedule.
– A change that raises aggregate demand shifts the DD
schedule to the right.
• These changes include a rise in investment, a rise in
government expenditures, and a reduction of taxes.
• They also include an increase in home prices or a reduction in
foreign prices that raise the real exchange rate for a given level
of the nominal exchange rate.
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Output Market Equilibrium
D
A rise in G
D=Y
D(SP*/P, Y – T, I, G2)
D(SP*/P, Y – T, I, G1)
S
Y1
Y2
Y
DD1
DD2
S
Y1
Y2
Y
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Asset Market Equilibrium
• The AA Schedule
– It shows all the equilibrium combinations of
output and the exchange rate that are consistent
with the home money market and the foreign
exchange market.
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Asset Market Equilibrium
– The AA schedule represents the asset market
equilibrium
– It combines the money market equilibrium with
the foreign exchange equilibrium (the
uncovered interest parity condition).
• M/P = L(i,Y)
• i = i* + (Se – S)/S
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Asset Market Equilibrium
A rise in Y
S
1'
S1
2'
S2
i* + (Se-S)/S
i
0
i1
i2
L(i, Y1)
L(i, Y2)
M
P
1
2
M/P
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Asset Market Equilibrium
• The equilibrium in asset markets requires:
– A rise in output is related to an appreciation of the
domestic currency.
• The AA Schedule
– It relates exchange rates and output levels that keep the
asset markets in equilibrium.
– It slopes downward because a rise in output causes a
rise in the interest rate and a home currency
appreciation.
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Asset Market Equilibrium
S
The AA Schedule
1
S1
2
S2
AA
Y1
Y2
Y
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Asset Market Equilibrium
• Factors that affect the AA schedule
– A change in the nominal exchange rate or of output is a
move along the AA schedule.
– An increase in the home stock of money or a reduction
in home prices shifts the AA schedule to the right.
– An increase in foreign interest rate or the expected
future exchange rate shifts the AA schedule to the right.
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Asset Market Equilibrium
S
A rise in M
S2
S1
i* + (Se-S)/S
0
i2
i1
L(i, Y)
USD Rates
of return
M1/P
M2/P
M/P
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Asset Market Equilibrium
S
A rise in M
S2
S1
AA2
AA1
Y
Y
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The Short-Run Equilibrium
• The short-run equilibrium brings equilibrium
simultaneously to both the output and asset
markets.
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The Short-Run Equilibrium
S
DD
S
Y
Y
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The Short-Run Equilibrium
• Reaching the short-run equilibrium.
– The asset markets always reacts more rapidly.
• So, we first must move toward the AA schedule.
– The goods market is sticky (from sticky prices),
and reacts more slowly.
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The Short-Run Equilibrium
Reaching the Equilibrium
S
DD
S2
S3
2
3
1
S1
AA
Y1
Y
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The Short-Run Equilibrium
• Reaching the short-run equilibrium
– At point 2, the foreign exchange market is out of
equilibrium. S is so high that i> i*+(Se-S)/S.
• There is an excess demand for home currency.
• So, S jumps down toward the AA schedule.
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The Short-Run Equilibrium
– At point 3, the goods market is out of equilibrium. S is
so high that Q = SP*/P is above its equilibrium level.
• This generates an excess demand for home goods.
• In response, the home economy ups Y and reduces
S, to reduce the excess demand. So, S and Y move
along the AA schedule slowly toward the DD
schedule
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Temporary Policy Changes
• Monetary policy
– Policy instrument is the stock of money
supplied.
• Fiscal policy
– Policy instrument is either taxes or government
expenditures.
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Temporary Policy Changes
• Temporary Policy Changes
– These policies have no effects on the expectations of
future exchange rates.
– We expect these changes to be temporary, and to have
no effect on the long-run expected exchange rate.
– So, we only worry about the short run, because we go
back to the initial equilibrium.
• For the following analysis, we assume that the
different scenario involve no responses of foreign
macroeconomic policies.
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Temporary Policy Changes
• A Temporary Increase in Money Supply
– The Money Market
• For fixed prices, the increase in the stock of money
generates an excess supply of money. This reduces
the home interest rate.
• The expansionary monetary policy also raises
output, which increases money demand. The effect,
however, is small. It slightly diminishes the
reduction in the home interest rate.
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Temporary Policy Changes
– The Foreign Exchange Market
• The lower interest rate makes foreign investment
more attractive. This generate an excess demand of
foreign currency. The result is that the foreign
currency appreciates (or the home currency
depreciates).
• This is a shift of the AA schedule to the right.
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Temporary Policy Changes
– The Goods Market
• The appreciation of the foreign currency raises the
real exchange rate (the price of a foreign basket of
goods). This creates an excess demand for home
goods: the home current account improves and
pushes output up.
• This is a slide along the DD schedule.
• In the long run:
– The initial equilibrium is restored.
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Temporary Policy Changes
A Temporary Monetary Expansion
S
DD
2
S2
1
S1
AA2
AA1
Y1
Y2
Y
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Temporary Policy Changes
• A Temporary Increase in Government
Expenditures
• In the short run:
– The Goods Market
• The increase in expenditures raises output.
• This is a right shift of the DD schedule.
• The ensuing reduction in the nominal exchange rate
lowers the real exchange rate, which generates a
deterioration of the current account. This small
effects slightly diminishes the increase in output
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Temporary Policy Changes
– The Money Market
• For fixed prices, the higher output raises the demand
for money and the home interest rate.
– The Foreign Exchange Market
• The higher interest rate makes foreign investment
less attractive. The result is that the foreign currency
depreciates.
• This is a slide along the AA schedule.
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Temporary Policy Changes
A Temporary Increase in Government Expenditures
S
DD1
DD2
1
S1
2
S2
AA
Y1
Y2
Y
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Temporary Policy Changes
• The Business Cycle
• Temporary fiscal and monetary policies can be
used to neutralize the effects of outside
disturbances that create recessions.
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Temporary Policy Changes
• For example, consider a temporary fall in world demand
for home goods.
– The fall in world demand creates a deterioration of the
home current account at current real exchange rate.
This shifts the DD schedule to the left, which lowers
output and raises the exchange rate.
• A temporary fiscal expansion (rise in G) would simply move
the DD schedule back to its original position. This restores
both output and the exchange rate.
• A temporary monetary expansion would shift the AA schedule
to the right. This restores output, but raises further raises the
exchange rate.
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Temporary Policy Changes
Countercyclical Policies: A fall in world demand
S
DD2
DD1
S3
3
2
S2
AA2
1
S1
AA1
Y2
Yf
Y
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Temporary Policy Changes
• For example, consider a temporary rise in money demand.
– The rise in money demand raises the home interest rate,
which generates an appreciation of the home currency
and a reduction of home output (via a deterioration in
the current account). This shifts the AA schedule to the
left.
• A temporary monetary expansion would shift the AA schedule
back to its original position, and restores both output and the
exchange rate.
• A temporary fiscal expansion (rise in G) would shift the DD
schedule to the right. This restores output, but further reduces
the exchange rate.
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Temporary Policy Changes
Countercyclical Policies: A rise in money demand
S
DD1
DD2
S1
1
2
S2
AA1
3
S3
AA2
Y2
Yf
Y
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Permanent Policy Changes
• Unlike temporary changes, permanent policy
changes potentially have long-run effects.
• These changes may affect the long-run exchange
rate, and our expectations of the future exchange
rate.
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Permanent Policy Changes
• A Permanent Increase in the Money Supply
• The Long Run: Perfect Price Flexibility
– The Money Market
• The rise in M only raises P. Money is neutral in the
long run.
– The Foreign Exchange Market
• The rise in P engineers a long-run depreciation of
the home currency (an increase in S).
• This is a shift of the AA schedule to the right.
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Permanent Policy Changes
– The Goods Market
• The rise in S offset any effects of the rise in P on the
real exchange rate and the current account.
• However, at the initial exchange rate, the higher P
means a reduction of the real exchange rate and a
reduction in output. This shifts the DD schedule to
the left.
• Thus, there are both movements of the DD schedule
and movements along the DD schedule.
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Permanent Policy Changes
• The Short Run: Fixed Price
– The Money Market
• The increase in the stock of money reduces the
home interest rate.
• It also raises output, which increases money
demand. The effect, however, is small.
• So, overall, the increase in M reduces i.
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Permanent Policy Changes
– The Foreign Exchange Market
• The lower interest rate makes foreign investment
more attractive. The result is that the foreign
currency appreciates.
• In addition, the rise in the long-run exchange rate
generates an increase in the expectations of the
future exchange rate. This further appreciates the
foreign currency.
• This is a shift of the AA schedule to the right.
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Permanent Policy Changes
– The Goods Market
• The appreciation of the foreign currency raises the
real exchange rate. This generates an improvement
in the current account and pushes output up.
• This is a slide along the DD schedule.
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Permanent Policy Changes
• The adjustment: the short run to the long run
– The Money Market:
• As prices rise, the interest rate and output are slowly
restored to the initial level.
– The Foreign Exchange Market:
• The rising home interest rate generates a
depreciation of the foreign currency.
– The Goods Market:
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Permanent Policy Changes
A permanent rise in M
DD2
DD1
S
2
S2
S3
S1
3
AA2
1
AA3
AA1
Yf
Y2
Y
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Permanent Policy Changes
• A Permanent Rise in Government Exp.
• The Long Run: Perfect Price Flexibility
– The Goods Market
• The increase in expenditures raises output.
• This raises the demand for home goods, and lowers
the price of foreign goods.
• The reduction in the real exchange rate lowers the
nominal exchange rate.
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Permanent Policy Changes
– The Money Market
• No changes in the long run.
– The Foreign Exchange Market
• The expected future exchange rate drops, lowering
the foreign return schedule.
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Permanent Policy Changes
• The Short Run: Fixed Price
– The Goods Market
• The increase in expenditures raises output.
• This is a right shift of the DD schedule.
• The ensuing reduction in the nominal exchange rate
lowers the real exchange rate and generates a
deterioration of the current account. This effect
cancels out the rise in output.
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Permanent Policy Changes
– The Money Market
• No changes.
– The Foreign Exchange Market
• The lower long-run exchange rate reduces the
expectations of future exchange rate. This generates
an immediate depreciation of the foreign currency.
• This is a left shift of the AA schedule.
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Permanent Policy Changes
S
DD1
DD2
S1
1
AA1
2
S2
AA2
Yf
Y
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The J-Curve
• The J-Curve
– Empirically, it has been observed that the
current account adjustment to a real exchange
depreciation follows a J-curve pattern.
• That is, a real depreciation generates first a
deterioration of the current account followed by an
important long-run improvement.
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The J-Curve
CA
1
3
Initial CA
2
Real
Depreciation
Time
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Summary
• Aggregate demand:
D  C (Y  T )  I  G  CA( SP * / P, Y  T )
• or
D  D( SP * / P, Y  T , I , G )
• Output is determined in the short run by Y=D.
Y  D( SP * / P, Y  T , I , G )
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Summary
• A temporary increase in the money supply causes
a depreciation of the currency and a rise in output.
• A permanent increase in the money supply only
causes a long-run depreciation of the currency
(and money is neutral). It causes a large
depreciation of the currency and a rise in output in
the short run. Thus, the currency appreciates
during the adjustment period.
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Summary
• A temporary increase in government expenditures
causes an appreciation of the currency and a rise
in output.
• A permanent increase in government expenditures
only causes a permanent appreciation of the
currency, and no changes in output.
• Empirically, the current account adjustment to a
real exchange depreciation follows a J-curve
pattern.
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