Output and the Exchange Rate in the Short Run Chapter 17 Krugman and Obstfeld 9e ECO41 International Economics Udayan Roy

Long Run and Short Run Long run theories are useful when all prices of inputs and outputs have enough time to adjust fully to changes in supply and demand. In the short run, some prices of inputs and outputs may not have time to adjust, due to labor contracts, costs of adjustment, or imperfect information about market demand. This chapter discusses a theory of the short run behavior of a “small” economy with flexible exchange rates under perfect capital mobility

The DD curve

Determinants of Aggregate Demand Aggregate demand (D) is the aggregate amount of goods and services that people are willing to buy. It consists of the following types of expenditure: consumption expenditure (C) investment expenditure (I) government purchases (G) net expenditure by foreigners: the current account (CA)

Determinants of Aggregate Demand Assumption: Consumption expenditure (C) increases when disposable income (Y − T)—which is income (Y) minus taxes (T)—increases … but by less than the increase in disposable income Real interest rates may influence the amount of saving and consumption, but we assume that they are relatively unimportant here. Wealth may also influence consumption, but we assume that it is relatively unimportant here.

Determinants of Aggregate Demand Assumption: The balance on the current account (CA) increases … … when the real exchange rate (q) increases Recall that the real exchange rate is the price of foreign products relative to the price of domestic products: q = EP*/P … when disposable income decreases more disposable income (Y-T) means more expenditure on foreign products (imports). Therefore, when Y−T rises, CA falls.

Determinants of Aggregate Demand Determinants of the current account include: Real exchange rate: an increase in the real exchange rate increases the current account. Disposable income: an increase in the disposable income decreases the current account.

Determinants of Aggregate Demand (cont.) Assumption: exogenous political factors determine government purchases (G) and the level of taxes (T). Assumption: investment expenditure (I) is determined exogenously by business sentiment. A more complex model might assume that investment depends on the expected real interest rate, which is the cost of borrowing for investment.

Determinants of Aggregate Demand (cont.) Aggregate demand is therefore expressed as: D = C(Y – T) + I + G + CA(E×P*/P, Y – T) Or more simply: D = D(E×P*/P, Y – T, I, G) Consumption depends on disposable income Investment and government purchases, both exogenous Current account depends on the real exchange rate and disposable income.

Determinants of Aggregate Demand (cont.) Aggregate demand is therefore expressed as: 𝐷=𝐶 𝑌−𝑇 +𝐼+𝐺+𝐶𝐴 𝐸× 𝑃 ∗ 𝑃 ,𝑌−𝑇 Or more simply: 𝐷=𝐷 𝐸× 𝑃 ∗ 𝑃 ,𝑌−𝑇,𝐼,𝐺 Consumption depends on disposable income Investment and government purchases, both exogenous Current account depends on the real exchange rate and disposable income. Blue (red) indicates a positive (negative) effect

Determinants of Aggregate Demand (cont.) Determinants of aggregate demand include: Real exchange rate: an increase in the real exchange rate increases the current account, and therefore increases aggregate demand for domestic products. Disposable income: an increase in the disposable income increases consumption, but decreases the current account. Since total consumption expenditure is usually greater than expenditure on foreign products, the first effect dominates the second effect. Therefore, When disposable income increases, aggregate demand increases, but by less than the increase in disposable income. Therefore, when income increases or taxes decrease (or both), aggregate demand increases.

Determinants of Aggregate Demand (cont.) Determinants of aggregate demand include: Government Spending: an increase in government spending (G) increases aggregate demand for domestic products (D). Business Investment: an increase in business investment (I) increases aggregate demand (D).

Short Run Equilibrium for Aggregate Demand and Output Equilibrium is achieved in the goods market when output equals aggregate demand: Y = D. 𝑌=𝐶 𝑌−𝑇 +𝐼+𝐺+𝐶𝐴 𝐸∙ 𝑃 ∗ 𝑃 ,𝑌−𝑇 or 𝑌=𝐷 𝐸× 𝑃 ∗ 𝑃 ,𝑌−𝑇,𝐼,𝐺 Value of output, income, and expenditure When this is combined with the full-employment condition Y = Yf, we get a long-run theory of q, the real exchange rate. Aggregate demand as a function of the real exchange rate, disposable income, investment, government purchases

Goods Market Equilibrium 𝑌=𝐶 𝑌−𝑇 +𝐼+𝐺+𝐶𝐴 𝐸∙ 𝑃 ∗ 𝑃 ,𝑌−𝑇 Note that only Y and E are endogenous (or, unknown) variables in this equation The others—T, I, G, P, and P*—are exogenous constants in our short-run analysis So, what does the goods market equilibrium equation tell us about how Y and E are related?

Goods Market Equilibrium 𝑌=𝐶 𝑌−𝑇 +𝐼+𝐺+𝐶𝐴 𝐸∙ 𝑃 ∗ 𝑃 ,𝑌−𝑇 If Y increases by, say, $100, then C will increase too, but by less. Let’s say C increases by $70 Then to maintain equilibrium, CA must increase (in this case, by $30) But the increase in Y, by itself, reduces CA So, the increase in Y must be accompanied by an increase in E (so that CA can increase, as necessary)

Goods Market Equilibrium: DD Curve 𝑌=𝐶 𝑌−𝑇 +𝐼+𝐺+𝐶𝐴 𝐸∙ 𝑃 ∗ 𝑃 ,𝑌−𝑇 For given values of the exogenous variables—T, I, G, P, and P*—the endogenous unknowns, Y and E, must move in the same direction

Goods Market Equilibrium: Shifts of the DD Curve 𝑌=𝐶 𝑌−𝑇 +𝐼+𝐺+𝐶𝐴 𝐸∙ 𝑃 ∗ 𝑃 ,𝑌−𝑇 Suppose the economy is initially at Point 1. Suppose there is a tax hike (T↑), but output is still at Y1. Then, C will decrease. Let’s say C decreases by $100. This will require CA to increase by $100. But T ↑, by itself, will increase CA by less than $100. 3 DD2 Why? When C falls by $100, the consumption of imported goods would fall by less: say, by $55. So, the tax cut, by itself, would increase CA by only $55. Therefore, to make CA increase by another $45, E must increase. So, the tax hike takes the economy from Point 1 to Point 3. In other words, a tax increase shifts the DD curve upward and to the left.

Goods Market Equilibrium: Shifts of the DD Curve 𝑌=𝐶 𝑌−𝑇 +𝐼+𝐺+𝐶𝐴 𝐸∙ 𝑃 ∗ 𝑃 ,𝑌−𝑇 Suppose the economy is initially at Point 2. Suppose I or G increases (I + G↑), but output is still at Y2. Then, CA must decrease. With unchanged Y, this requires a decrease in E. Therefore, if I or G increases and Y is unchanged, then the economy must move from Point 2 to Point 3. In other words, if I or G increases, the DD curve must shift downward or to the right. 3 DD2

Goods Market Equilibrium: Shifts of the DD Curve 𝑌=𝐶 𝑌−𝑇 +𝐼+𝐺+𝐶𝐴 𝐸∙ 𝑃 ∗ 𝑃 ,𝑌−𝑇 Suppose the economy is initially at Point 2. Suppose P* increases or P decreases (P*/P ↑), but output is still at Y2. Then, CA must stay unchanged. With Y and T unchanged, the only way CA can remain unchanged in spite of P*/P ↑ is if E decreases enough to keep the real exchange rate unchanged. Therefore, if P* increases or P decreases and Y is unchanged, then the economy must move from Point 2 to Point 3. In other words, if P* increases or P decreases , the DD curve must shift downward or to the right. 3 DD2

Fig. 17-2: The Determination of Output in the Short Run Output is greater than aggregate demand: firms decrease output Aggregate demand is greater than production: firms increase output

Short Run Equilibrium and the Exchange Rate: DD Schedule How does the value of the foreign currency (E) affect the short run equilibrium of aggregate demand and output? Domestic and foreign price levels (P and P*) are assumed fixed in the short run. Therefore, a rise in the nominal exchange rate (E) makes foreign goods more expensive relative to domestic goods. That is, q = E × P*/P increases when E increases. As a result, CA increases and, therefore, D increases. That is, D increases when E increases. See Fig 17-3. In equilibrium, Y = D. Therefore, Y increases when E increases. This gives the DD curve. See Fig 17-4. Y = D(E×P*/P, Y – T, I, G)

Fig. 17-3: Output Effect of a Currency Depreciation with Fixed Output Prices Y = D(E×P*/P, Y – T, I, G)

Fig. 17-4: Deriving the DD Schedule Y = D(E×P*/P, Y – T, I, G)

Shifting the DD Curve Changes in the exchange rate cause movements along a DD curve. Other changes may cause it to shift: Changes in G: more government purchases cause higher aggregate demand and output in equilibrium. Output increases for every exchange rate: the DD curve shifts right.

Fig. 17-5: Government Demand and the Position of the DD Schedule An increase in G causes the DD curve to shift to the right. The same rightward shift of the DD curve happens if: I increases T decreases P*/P increases Y = D(E×P*/P, Y – T, I, G)

Shifting the DD Curve The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason CA increases for some unknown reason Y = D(E×P*/P, Y – T, I, G)

The aa curve

Short Run Equilibrium for Assets We consider two asset markets when considering asset market equilibrium: Ch 14: Foreign exchange market interest parity: R = R* + (Ee – E)/E Ch 15: Money market real money supply and demand determine equilibrium: Ms/P = L(R, Y)

Equilibrium in Asset Markets Let us simplify the money market equilibrium equation to 𝑀 𝑠 𝑃 = 𝐿 0 ∙𝑌 𝑅 or equivalently to 𝑌= 𝑀 𝑠 𝐿 0 ∙𝑃 ∙𝑅 The interest parity equation then yields 𝑌= 𝑀 𝑠 𝐿 0 ∙𝑃 ∙ 𝑅 ∗ + 𝐸 𝑒 𝐸 −1 This is the equation for the AA curve

Fig. 17-7: The AA Schedule

Equilibrium in Asset Markets 𝑌= 𝑀 𝑠 𝐿 0 ∙𝑃 ∙ 𝑅 ∗ + 𝐸 𝑒 𝐸 −1 Suppose the economy is initially at Point 2 Suppose there is a decrease in Ms or R* or Ee, or an increase in L0 or P If E stays unchanged at E2, then Y must decrease The economy must go from Point 2 to, perhaps, Point 3 In other words, a decrease in Ms or R* or Ee, or an increase in L0 or P shifts the AA curve left AA2 3

What makes the value of the euro (E) change? Note the inverse relation between Y and E. This yields another curve linking Y and E: the AA curve. M/P (-) (+) R Y (-) Domestic preference for cash (+) E (+) M*/P* (-) R* (+) Y* (+) Ee Foreign preference for cash (+)

Recap: What makes (E), the value of the foreign currency, change? Note the inverse relation between Y and E. This yields another curve linking Y and E: the AA curve. M/P (-) (+) R Y But E is also affected by changes in M/P, Ee, and L, the preference for cash. (-) Domestic preference for cash (+) E (+) M*/P* (-) R* (+) Y* (+) Ee Foreign preference for cash (+)

Shifting the AA Curve The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason E E0 E1 Y Y0 Y1

Short-run macroeconomic equilibrium

Putting the Pieces Together: the DD and AA Curves A short run equilibrium means that the exchange rate (E) and output (Y) are such that there is equilibrium in: the output market: aggregate demand (D) equals aggregate output (Y). the foreign exchange market: interest parity holds. the money market: real money supply (MS/P) equals real money demand (L). Y = D(E×P*/P, Y – T, I, G)

Fig. 17-8: Short-Run Equilibrium: The Intersection of DD and AA The short run equilibrium occurs at the intersection of the DD and AA curves The output market is in equilibrium on the DD curve The asset markets are in equilibrium on the AA curve

Shifting the AA and DD Curves The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason CA increases for some unknown reason The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason Knowing how some specified change shifts the DD and AA curves will help us predict the consequences of the specified change.

Short-run effects of temporary changes in government policy

Temporary Changes in Monetary and Fiscal Policy Monetary policy: policy in which the central bank influences the money supply (MS). Monetary policy primarily influences asset markets. Fiscal policy: policy in which governments influence the amount of government purchases (G) and taxes (T). Fiscal policy primarily influences aggregate demand (D). Temporary policy changes are expected to be reversed in the near future and thus do not affect expectations about exchange rates in the long run. Specifically, temporary changes in MS, G, and T do not affect Ee.

Shifting the AA and DD Curves The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason CA increases for some unknown reason The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason (L0↓)

Temporary Changes in Monetary Policy When there is an increase in the supply of money The AA shifts up (right) and DD is unaffected. Both E and Y increase R decreases As Ee is unaffected when the change in Ms is temporary, the increase in E leads to a decrease in R; recall R = R* + (Ee/E) – 1. E DD E0 Y Y0

Fig. 17-10: Effects of a Temporary Increase in the Money Supply R*↑ and Ee ↑ have the same effect, as does a fall in money demand (L).

Effect of Temporary MS↑ on CA There are two ways to figure out the effect of a change in an exogenous variable on a country’s current account Recall that 𝑌=𝐶 𝑌−𝑇 +𝐼+𝐺+𝐶𝐴 𝐸∙ 𝑃 ∗ 𝑃 ,𝑌−𝑇 in goods market equilibrium Method 1: 𝐶𝐴=𝐶𝐴 𝐸∙ 𝑃 ∗ 𝑃 ,𝑌−𝑇 Method 2: 𝐶𝐴=𝑌−𝐶 𝑌−𝑇 −𝐼−𝐺 We will return to Ch. 16 and use this to analyze the long-run behavior of CA.

Effect of Temporary MS↑ on CA Method 2: 𝐶𝐴=𝑌−𝐶 𝑌−𝑇 −𝐼−𝐺 An increase in Ms causes Y to increase. But C(Y – T) increases less than Y does. Therefore, CA must increase. That is, an increase in the supply of money, leads to an increase in the current account balance (or, net exports) R*↑ and Ee ↑ have the same effect, as does a fall in money demand (L).

Changes in Ee and R* Any increase in Ee, the expected future value of the foreign currency, or in R*, the foreign interest rate cause the same shifts as expansionary monetary policy: they shift the AA curve rightward and do not affect the DD curve Therefore, Y↑ and E↑. As P and P*, being exogenous, are unaffected, E↑ implies q↑

Changes in Ee and R* Recall that the money market’s equilibrium equation is 𝑀 𝑠 𝑃 = 𝐿 0 ∙𝑌 𝑅 or, equivalently, 𝑅= 𝐿 0 ∙𝑃∙𝑌 𝑀 𝑠 As L0, P, and Ms, being exogenous, are unaffected by increases in Ee or R*, the fact that Y↑ implies R↑

Changes in Ee and R* Recall that 𝐶𝐴=𝑌−𝐶 𝑌−𝑇 −𝐼−𝐺 We have just seen that Ee↑ or R*↑ causes Y↑ When Y↑ and T is unchanged, C increases but by less. Therefore, Y − C↑ As I and G are exogenous and, therefore, unaffected by changes in Ee or R*, it must be that CA↑

Temporary Changes in Fiscal Policy An increase in government purchases or a decrease in taxes increases aggregate demand and output. The DD curve shifts right. Higher output increases real money demand, and thereby increases interest rates, causing an increase in the value of the domestic currency (a fall in E).

Shifting the AA and DD Curves The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason CA increases for some unknown reason The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason

Fig. 17-11: Effects of a Temporary Fiscal Expansion G ↑ and/or T ↓ P*↑ and I↑ have the same effect, as do shocks that increase C and CA. E↓ implies R↑ because R = R* + (Ee/E) – 1.

Effect of G↑ and/or T↓ on CA When G↑ and/or T↓ — this is called expansionary fiscal policy — E↓ and Y↑. Therefore, CA↓. Expansionary (contractionary) fiscal policy reduces (increases) net exports.

Fig. 17-12: Maintaining Full Employment After a Temporary Fall in World Demand for Domestic Products Temporary fall in world demand for domestic products reduces output below its normal level Temporary monetary expansion could depreciate the domestic currency Temporary fiscal policy could reverse the fall in aggregate demand and output

Fig. 17-13: Policies to Maintain Full Employment After a Money Demand Increase Temporary monetary policy could increase money supply to match money demand Increase in money demand raises interest rates and appreciates the domestic currency Temporary fiscal policy could increase aggregate demand and output

Effects of an increase in investment Simply put, the effects of I↑ are exactly the same as those of G↑ Therefore, we can predict that if G↑ and/or I↑, then E↓, q↓, Y↑, R↑, and CA↓.

Effects of a change in foreign prices We saw three slides back that P*↑ causes the DD curve to shift right and has no effect on the AA curve Therefore, E↓ and Y↑. And, following the same steps as in our discussion of the effects of Ee↑ and R*↑, we can prove that CA↑

Shifting the AA and DD Curves The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason CA increases for some unknown reason The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason

Effects of a change in domestic prices Recall that P↓ causes both AA and DD curves to shift rightward Therefore, Y↑ is certain But E could decrease, stay unchanged, or increase, as in the three diagrams below E E E DD DD DD AA AA AA Y Y Y

Effects of a change in domestic prices Following the same steps as in our discussion of the effects of Ee↑ and R*↑ and P*↑, we can prove that CA↑ Finally, the interest parity equation (𝑅= 𝑅 ∗ + 𝐸 𝑒 𝐸 −1) implies that, as Ee and R* are exogenous and, therefore, unaffected by P↓, the ambiguous behavior of E implies R too could decrease, stay unchanged, or increase

Summary: Short Run Predictions, Flexible Exchange Rate System DD AA Y NX q E R I, G → + − T ← Ms P ? Ee P* R* The exogenous variables—policy variables and ‘shocks’—are listed on the first column and the endogenous unknowns are listed on the first row. The predictions above are for temporary changes in the exogenous variables. The 2nd and 3rd columns show how the DD and AA curves are shifted by an increase in the exogenous variables.

Short-run effects of permanent changes in government policy

Permanent Changes in Monetary and Fiscal Policy Permanent policy changes modify people’s expectations about future exchange rates (Ee) … … when they change the long-run value of E.

Permanent Increase in Money Supply The AA curve shifts right because of the increase in MS. The equilibrium moves from point 1 to point 3 in Fig 17-14. In the long run, E will rise. See Table 16-1. This will have the immediate effect of raising Ee. The increase in Ee shifts the AA curve to the right again. The equilibrium moves from point 3 to point 2 in Fig 17-14. Both E and Y increase more for a permanent increase in MS than for a temporary increase in MS.

Fig. 17-14: Short-Run Effects of a Permanent Increase in the Money Supply

Table 16-1: Effects of Money Market and Output Market Changes on the Long-Run Nominal Dollar/Euro Exchange Rate, E$/€

Permanent ↑ in Ms: Overshooting? AA1 is the initial AA curve AA2 is AA1 plus effect of Ee↑ caused by permanent ↑ in Ms. AA3 is AA2 plus effect of Ms/P↑ caused by permanent ↑ in Ms. In the long run, Ms/P returns to original level. So, the economy goes from a green dot to a black dot in the short run, and to the higher of the two green dots in the long run. E E E DD2 DD2 DD2 DD1 DD1 DD1 AA3 AA3 AA3 AA2 AA2 AA2 AA1 AA1 AA1 Yf Y Yf Y Yf Y Overshooting Neither over nor under! Undershooting

Macroeconomic Policies and the Current Account By recalling the effects of various policies on the real dollar/euro exchange rate (q = EP*/P) and on disposable income (Yd = Y − T), we can figure out their effects on the current account (CA).