International Finance
Chapter 7
The Balance of Payment II: Output, Exchange
Rates, and Macroeconomic Policies in the Short
Run
1
Notes to the Chapter
• In previous chapters, output is assumed to be
exogenous. Now, we are to analyze how output
and exchange rates are determined in the short
run.
• In macroeconomics, monetary and fiscal policies
only work in the short run. In an open economy,
total spending is equal to C+I+G+NX. Therefore,
in the short run, we can relate exchange rates to
output, current account balance and analyze how
policies could restore full-employment in an open
economy.
2
Chapter Outline
• Determinants of aggregate demand in the short run
• A short run model of output markets
• A short run model of asset markets
• A short run model for both output markets and asset
markets
• Effects of monetary and fiscal policies in the short run
3
Determinants of Aggregate Demand
Aggregate demand is the aggregate amount
of goods and services that individuals and
institutions are willing to buy:
AD = C + I + G + NX
–
–
Assume investment expenditure and government
purchases are fixed;
What factors determine consumption spending
and net exports (current account) in the short
run?
4
Determinants of Consumption Expenditure
• Disposable income: total income (Y) minus net taxes
(T).
– More disposable income means more consumption
expenditure, but consumption typically increases
less than the amount that disposable income
increases.
• Real interest rates may influence the amount of
saving and spending on consumption goods, but we
assume that they are relatively unimportant here.
• Wealth may also influence consumption expenditure,
but we assume that it is relatively unimportant here.
5
Determinants of Current Account
• Determinants of the current account include:
– Disposable income: more disposable income
means more expenditure on foreign products
(imports)
– Real exchange rate: EP*/P
 As real exchange rate increases, domestic goods
become cheaper. Therefore, exports to foreign countries
increase and imports from foreign countries decrease.
 The volume and the value of exports increase since
exports are already measured in home currency. Would
the volume and the value of imports measured in home
currency both decrease?
6
How Real Exchange Rate Changes Affect the
Imports from Foreign Countries
•
CA ≈ EX – IM.
IM (measured in home products) = (EP*/P)·Q*
1. The volume of imports that are bought by domestic
residents falls.
2. The value of imports in terms of domestic products rises
since the EP*/P increases.
3. So, what is the net effect of real exchange rate on imports?
– Assuming volume effect is larger than the value effect,
imports decrease when real exchange rate increases.
4. Therefore, current account increases as real exchange rate
increases.
7
Determinants of Aggregate Demand
(cont.)
• Aggregate demand is therefore expressed as:
AD = C(Y – T) + I + G + CA(EP*/P, Y – T, Y* – T*)
• Or more simply:
AD = AD(EP*/P, Y – T, I, G, Y*-T*)
– T, I, G, Y*, and T* are assumed fixed;
– As Y increases, consumption rises but current account falls.
Usually, consumption expenditure is greater than imports;
– An increase in the real exchange rate increases the current
account, and therefore increases aggregate demand of
domestic products.
8
Short Run Equilibrium for Aggregate Demand
and Output
• Equilibrium is achieved when the value of
income from production (output) Y equals the
value of aggregate demand D (expenditure
approach on the national account of output).
Y = D(EP*/P, Y – T, I, G, Y*-T*)
9
Figure: The Determination of Output in
the Short Run
Aggregate
demand is
greater than
production:
firms increase
output
Production is greater
than aggregate
demand: firms
decrease output
10
Short Run Equilibrium and the Exchange
Rate: DD Schedule
How does the exchange rate affect the short run
equilibrium of aggregate demand and output?
11
Figure 2: Deriving the DD Schedule
12
Short Run Equilibrium in Asset Markets
13
Short Run Equilibrium in Asset Markets (cont.)
• When income and production increase,
– demand of real monetary assets increases,
– leading to an increase in domestic interest rates,
– leading to an appreciation of the domestic
currency.
• The inverse relationship between output and
exchange rates needed to keep the foreign
exchange markets and the money market in
equilibrium is summarized as the AA curve.
14
Figure 3: The AA Schedule
Equilibrium exchange
rate in foreign
exchange market;
Equilibrium output in
money market.
15
Figure 4: Short-Run Equilibrium: The
Intersection of DD and AA
16
Figure 5: How the Economy Reaches Its
Short-Run Equilibrium
Exchange rates
adjust immediately
so that asset
markets are in
equilibrium.
The domestic
currency
appreciates and
output increases
until output markets
are in equilibrium.
17
Temporary Changes in Monetary Policy
• An increase in the quantity of monetary assets
supplied lowers interest rates in the short run,
causing the domestic currency to depreciate
(a rise in E).
– The AA shifts up (right).
– Domestic products relative to foreign products are
cheaper so that aggregate demand and output
increase until a new short run equilibrium is
achieved.
Figure 6: Effects of a Temporary
Increase in the Money Supply
Temporary Changes in Fiscal Policy
• An increase in government purchases or a
decrease in taxes increases aggregate
demand and output in the short run.
– The DD curve shifts right.
– Higher output increases demand of real monetary
assets,
– thereby increasing interest rates,
– causing the domestic currency to appreciate
(a fall in E).
Figure 7: Effects of a Temporary Fiscal
Expansion
Figure 8: Maintaining Full Employment After a Temporary Fall
in World Demand for Domestic Products
Temporary fiscal policy could reverse
the fall in aggregate demand and
output
Temporary fall in world demand
for domestic products reduces
output below its normal level
Temporary
monetary
expansion could
depreciate the
domestic
currency
Policies to Maintain Full Employment After a
Money Demand Increase
• Can you draw a diagram to demonstrate
how a monetary / a fiscal policy restore the
economy back to full employment level?
Permanent Changes in Monetary and Fiscal
Policy
• “Permanent” policy changes are those that
are assumed to modify people’s expectations
about exchange rates in the long run.
Figure 9: Short-Run Effects of a Permanent
Increase in the Money Supply
A permanent increase
in the money supply
decreases interest
rates and causes
people to expect a
future depreciation,
leading to a large
actual depreciation
Figure 10: Effects of Permanent Changes in
Monetary Policy in the Long Run
Higher prices make domestic products
more expensive relative to foreign goods:
reduction in aggregate demand
Higher prices reduce
real money supply,
Increasing interest
rates, leading to a
domestic currency
appreciation
In the long run,
output returns
to its normal
level, and we
also see
overshooting:
E1 < E3 < E2
Figure 11: Effects of Permanent Changes in
Fiscal Policy
An increase in
government
purchases raises
aggregate demand
Temporary fiscal
expansion outcome
When the increase of
government purchases
is permanent, the
domestic currency is
expected to
appreciate, and does
appreciate.
Monetary Policy and Fixed Exchange
Rates
• When the central bank buys and sells foreign
assets to keep the exchange rate fixed and to
maintain domestic interest rates equal to
foreign interest rates, it is not able to adjust
domestic interest rates to attain other goals.
– In particular, monetary policy is ineffective in
influencing output and employment.
28
Figure 12: Monetary Expansion is Ineffective
Under a Fixed Exchange Rate
29
Fiscal Policy and Fixed Exchange Rates
in the Short Run
• Temporary changes in fiscal policy are more
effective in influencing output and employment
in the short run:
– The rise in aggregate demand and output due to
expansionary fiscal policy raises demand of real
monetary assets, putting upward pressure on
interest rates and on the value of the domestic
currency.
– To prevent an appreciation of the domestic
currency, the central bank must buy foreign assets,
thereby increasing the money supply and
decreasing interest rates.
30
Figure 13: Fiscal Expansion Under a Fixed
Exchange Rate
A fiscal expansion increases
aggregate demand
To prevent the
domestic currency
from appreciating, the
central bank
buys foreign assets,
increasing the
money supply
and decreasing
interest rates.
31
Fiscal Policy and Fixed Exchange Rates
in the Long Run
• What happens to DD and AA curves in the long run
as a result of an expansionary fiscal policy?
• What happens to nominal and real exchange rates in
the long run?
32
Value Effect, Volume Effect and the
J-curve
• If the volume of imports and exports is fixed in the
short run, a depreciation of the domestic currency
– will not affect the volume of imports or exports,
– but will increase the value/price of imports in domestic
currency and decrease the current account: CA ≈ EX – IM.
– The value of exports in domestic currency does not change.
• The current account could immediately decrease after
a currency depreciation, then increase gradually as
the volume effect begins to dominate the value effect.
Figure 14: The J-Curve
volume effect
dominates
value effect
Immediate
effect of real
depreciation
on the CA
J-curve: value
effect dominates
volume effect