Prices and Output in the Open Economy: Aggregate Supply and Demand Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Chapter 27

27-2 Learning Objectives  Explain the fundamental links between international transactions and aggregate supply and aggregate demand.  Demonstrate how economic shocks and policies affect prices and output.  Differentiate between macroeconomic adjustment under fixed exchange rates and under flexible exchange rates.  Distinguish between short-run and long-run effects of macro policies on output and prices.

27-3 Aggregate Demand in the Closed Economy  In the closed economy, macroeconomic equilibrium occurs where IS and LM curves intersect.  When prices change, IS curve is not affected.  When prices change, real money supply changes, shifting the LM curve.  We can trace out the aggregate demand (AD) curve by seeing how Y changes as P changes.

Derivation of Aggregate Demand Curve: Closed Economy i YY P IS LM 0 (P 0 ) Y0Y0 i0i0 P0P0 Y0Y0 LM 1 (P 1 ) Y1Y1 i1i1 P1P1 LM 2 (P 2 ) Y2Y2 i2i2 Y1Y1 Y2Y2 P2P2 AD 27-4

27-5 Aggregate Demand in the Closed Economy  The more elastic IS or LM are, the more elastic AD will be.  If IS shifts right (left), AD shifts right (left).  An increase in the tax rate makes IS and AD steeper.  When LM shifts right (left), AD shifts right (left).

27-6 Aggregate Supply in the Closed Economy  AS is determined by: level of technology, quantity of resources available, efficiency with which resources are used, and level of employment of resources.  In the short run, the first 3 are assumed fixed.  Employers hire workers up to the point where wage equals the marginal revenue product: W=PMPP N.

Aggregate Production and the Demand for Labor Y N N W, MPP N IS N0N0 Y0Y0 W0W0 N0N0 N1N1 Y1Y1 N2N2 Y2Y2 Y1Y1 Y2Y2 MRP N0 MRP N1 MRP N2 27-7

27-8 Aggregate Supply in the Closed Economy  Suppose W is fixed – this mean firms can hire as much labor as they wish at the going wage (labor supply is perfectly elastic).  If P increases, MRP N shifts rightwards.  This leads to a higher level of employment and thus output.  Therefore P and Y are directly related.

27-9 The Aggregate Supply Curve With a Fixed Wage P YY2Y2 Y0Y0 P0P0 P2P2 Y1Y1 P1P1 AS

27-10 Aggregate Supply in the Closed Economy  However, labor supply is probably not perfectly elastic – to induce a greater quantity of labor supplied, wages must rise.  The resulting AS curve will be steeper.

Variable Wages and the Aggregate Supply Curve W, MRP Y P N0N0 W0W0 P0P0 Y0Y0 N1N1 W1W1 N2N2 W2W2 Y1Y1 Y2Y2 MRP 1 MRP 0 MRP 2 P2P2 P1P1 AS NSNS 27-11

27-12 Aggregate Supply in the Closed Economy  In fact, the quantity of labor supplied depends on the real wage.  Once workers realize that P has risen they will demand a higher wage.  This means that an increase in P may temporarily “fool” workers into supplying a higher quantity labor (and thus produce more output), but labor supply will shift leftwards eventually; Y returns to natural level of income.

27-13 Labor Market Adjustment to Higher Prices P Y MRP N W0W0 W2W2 MRP' N W1W1 SNSN S' N N0N0 N1N1

27-14 Equilibrium in the Closed Economy  Putting aggregate supply and aggregate demand together allows us to see equilibrium output and price level.  If for whatever reason AD increases, there will be a temporary increase in output and prices.  Once workers realize P has increased, they will decrease labor supply.  This will shift AS leftwards, leaving us with the original Y but a higher price level.

27-15 Equilibrium in the Closed Economy P YY0Y0 P0P0 P2P2 Y1Y1 P1P1 AS SR0 AD 0 AD 1 AS SR1 AS LR

27-16 Equilibrium in the Closed Economy  The short run AS curve is upward- sloping.  The long run AS curve is a vertical line.

27-17 Aggregate Demand in the Open Economy Under Fixed Rates  When the economy is open, we must also consider the BP curve when deriving AD.  If P increases: LM shifts leftwards. BP shifts leftwards. IS shifts leftwards.  Ultimately, a new equilibrium will occur at a lower level of Y.

Aggregate Demand in the Open Economy Under Fixed Rates i Y Y P IS P0 Y0Y0 i0i0 P0P0 Y0Y0 Y1Y1 i1i1 Y1Y1 P1P1 AD LM P0 BP P0 LM P1 BP P1 IS P

27-19 Aggregate Demand in the Open Economy Under Flexible Rates  If P increases: LM shifts leftwards. BP shifts leftwards. IS shifts leftwards.  An incipient surplus or deficit may ensue, causing exchange rate adjustment and further shifts of BP and IS.  Ultimately, a new equilibrium will occur at a lower level of Y.

27-20 Effect of Exogenous Shocks on AD Curve Under Fixed and Flexible Rates FixedFlexible Δ in partner-country variable that increases home- country exports AD shifts right No effect on AD Δ in partner-country variable that alters short-term capital flows in partner-country’s favor AD shifts left AD shifts right Δ in home-country variable that reduces home- country exports AD shifts left No effect on AD Δ in home-country variable that stimulates short- term capital inflows AD shifts right AD shifts left Expansionary monetary policyNo effect on AD AD shifts right Expansionary fiscal policyAD shifts right Little effect on AD

27-21 Monetary Policy in AS/AD Framework: Flexible Rates  Since monetary policy in the presence of fixed rates has limited effect on AD, we focus on a flexible rate regime.  Expansionary monetary policy shifts AD rightwards, with higher Y and P.  Eventually, workers realize P is higher and decrease labor supply.  This shifts AS leftwards.  The economy return to the original level of Y, but with higher P.

27-22 Monetary Policy in AS/AD Framework: Flexible Rates P Y Y0Y0 P0P0 P2P2 Y1Y1 P1P1 AS SR0 AD 0 AD 1 AS SR1 AS LR

27-23 Fiscal Policy in AS/AD Framework: Fixed Rates  Since fiscal policy in the presence of flexible rates has limited effect on AD (esp. if capital is relatively mobile), we focus on a fixed rate regime.  Expansionary fiscal policy shifts AD rightwards, with higher Y and P.  Eventually, workers realize P is higher and decrease labor supply.  This shifts AS leftwards.  The economy return to the original level of Y, but with higher P.

27-24 Fiscal Policy in AS/AD Framework: Fixed Rates P Y Y0Y0 P0P0 P2P2 Y1Y1 P1P1 AS SR0 AD 0 AD 1 AS SR1 AS LR

27-25 Economic Policy and Supply Considerations  Some policies can also affect AS.  For example, suppose a tax cut not only expands AD, but also causes AS to shift to the right, as supply-side economists predict?  The tax cut will end up increasing Y, but the ultimate effect on P is ambiguous.

27-26 Economic Policy and Shifts in the Long-Run AS Curve P YY0Y0 P0P0 Y1Y1 AS SR0 AD 0 AD 1 AS SR1 AS LR AS' LR ? ?

27-27 External Shocks: Increase in Price of Imported Input  What if a critical imported input (e.g., crude oil) increases in price?  In a flexible exchange rate system, this causes a depreciation of the home currency, an expansion of AD, and a leftward shift of short- and long-run AS.  The result may be stagflation: simultaneous decreases in income coupled with rising prices.

27-28 Effect of a Price Shock of an Imported Input P Y Y0Y0 P0P0 Y1Y1 P1P1 AS SR0 AD 0 AD 1 AS SR1 AS LR0 AS LR1 Y2Y2

27-29 External Shocks: Foreign Financial Shock  What if a foreign financial shock triggers an inflow of short-term capital?  In a flexible exchange rate system, this causes an appreciation of the home currency, an contraction of AD, and lower income and prices.  The economy could return to original Y by expansionary monetary or fiscal policy, or wait for the LR adjustment.

27-30 External Shocks: Foreign Financial Shock P Y Y0Y0 P0P0 Y1Y1 P1P1 AS SR0 AD 0 AD 1 AS LR0

27-31 External Shocks: Technological Change  What if technological change occurs?  SR AS shifts rightwards, temporarily giving us a new equilibrium with higher income and lower prices (at P 1 and Y 1 ).  But LR AS also shifts rightwards, perhaps to the right of Y 1.  Now the economy is below its new natural level, Y 2.  The economy will adjust by a further rightward shift of SR AS, or expansionary monetary or fiscal policy could be employed.

27-32 External Shocks: Technological Change P Y Y0Y0 P0P0 Y1Y1 P1P1 AS SR0-W0 AD 0 AD 1 AS LR0 AS SR1-W0 AS LR1 Y2Y2 P2P2 AS SR1-W1