1. Output and the Exchange Rate in the Short Run
Chapter 16
Output and the Exchange Rate in the Short Run

2. Preview Determinants of aggregate demand in the short run
A short run model of output market equilibrium
A short run model of asset market equilibrium
A short run model for both output market equilibrium and asset market equilibrium
Effects of temporary and permanent changes in monetary and fiscal policies.
Adjustment of the current account over time.

3. Introduction
LR models are useful when all prices of inputs and outputs have time to adjust.
In the SR, 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 builds on the previous models of exchange rates to explain how output is related to exchange rates in the short run.
macroeconomic policies affect output, employment and the current account.

4. Determinants of Aggregate Demand (AD)
AD= aggregate amount of goods and services that people are willing to buy:
consumption expenditure: C
investment expenditure: I
government purchases: G
net expenditure by foreigners: the current account, CA.
AD = C+I+G+CA

5. Determinants of AD Determinants of C : Determinants of CA≈ EX – IM
-Disposable income (Yd): income from production (Y) minus taxes (T). ↑ Yd means ↑ C but ↑C < ↑ Yd.
Real interest rates may influence the amount of saving and C, and wealth may influence C but we assume that they are unimportant
Determinants of CA≈ EX – IM
-Disposable income: ↑ Yd means more expenditure on foreign products (imports), IM ↑ thus CA↓.
-Foreign income: ↑ Y* means more expenditure by foreigners on our products, EX ↑ thus CA ↑.
-Real exchange rate: prices of foreign products relative to the prices of domestic products, both measured in domestic currency: EP*/P
As the prices of foreign products rise relative to those of domestic products, expenditure on domestic products rises and expenditure on foreign products falls.

6. How Real Exchange Rate Changes Affect CA
The CA measures the value of exports relative to the value of imports: CA ≈ EX – IM.
When the real exchange rate EP*/P (q) rises, foreign products become expensive relative to domestic products.
The volume of exports bought by foreigners ↑: ↑CA
The volume of imports bought by domestic residents↓: ↑CA
The value of imports in terms of domestic products ↑: the value/price of imports rises, since foreign products are more valuable/expensive: ↓CA
Evidence indicates that for most countries the volume effect dominates the value effect in 1 year or less. Therefore, we assume that the volume effect dominates the value effect:
A real depreciation (↑ q) leads to a ↑CA surplus.

7. Determinants of AD (cont.)
We assume that exogenous political factors determine government purchases G and the level of taxes T.
For simplicity, we currently assume that investment expenditure I is determined exogenously.
A more complicated model shows that investment depends on the cost of borrowing for investment, the interest rate.

8. Determinants of AD (cont.)
AD is therefore expressed as:
D = C(Y – T) + I + G + CA(EP*/P, Y – T,Y*)
Or more simply:
D = D(EP*/P, Y – T, I, G,Y*)
Consumption
as a function
of disposable
income
Investment and
government
purchases, both
exogenous
Current account as
a function of the real
exchange rate and
disposable income.

9. Determinants of AD (cont.)
Determinants of aggregate demand include:
Real exchange rate (EP*/P=q): a ↑in q ↑ CA, and therefore ↑ AD for domestic products.
Disposable income: a ↑ in Yd ↑C, but ↓ CA.
Since total C expenditure is > expenditure on foreign products, the 1st effect dominates the 2nd effect.
As Y ↑ for a given level of taxes, C and AD ↑ < ↑ Y

10. SR Equilibrium for AD and Output Y
Equilibrium is achieved when the value of output Y (and income from production) = AD.
Y = D( EP*/P, Y–T, I, G, Y* )
Value of output,
income from
production
Equilibrium condition
Aggregate demand as a function of the
real exchange rate, disposable income,
investment, government purchases
Note: despite its similarity with the national income identity, this is not an accounting identity: it is an equilibrium condition.
The equilibrium is where the LHS and RHS, plotted as functions of Y, intersect.

11. Figure 16-2: The Determination of Output in the Short Run
Output, Y
Aggregate
demand, D
AD<Y,
Firms decrease output
Output, Y AD 3 Y3 D1 1 Y1 2 Y2
AD>Y, firms
Increase output
45°

12. Output Market Equilibrium
The previous analysis determines Y given EP*/P. We now determine Y and EP*/P jointly in the SR, in the output and the asset markets.
Note: With fixed prices, changes in EP*/P ≡ changes in E.
The DD schedule shows combinations of Y and E for which the output market is in SR equilibrium (AD = Y).
A rise in EP*/P (due to a rise in E, P* or fall in P) makes foreign output more expensive than domestic output. This increases AD (shifts the AD schedule up). In equilibrium, Y matches AD, hence Y increases (vice versa for a fall in EP*/P).
****Hence, the DD schedule slopes upward***

13. Figure 16-4: The DD Schedule
Output, Y
Aggregate demand, D
D = Y
AD (E2, P, P*, G, I Y*)
Currency
depreciates
AD (E1, P, P*, G, I, Y* ) Y2 Y1 Y1 Y2
Output, Y
Exchange rate, E DD
E 2 2 1
E 1

14. Factors that shift the DD curve
Changes in the exchange rate cause movements along a DD curve. Factors other than E causing an increase in AD, shift the AD schedule up and the DD schedule to the right:
for ex: ↑ G → ↑ AD and Y in equilibrium. Y ↑ for every E: DD curve shifts right.
Higher government expenditure G
Lower taxes T
Higher investment I
A fall in domestic prices P
A rise in foreign prices P*
Higher domestic consumption due to change in tastes
Structural demand shifts from foreign to domestic goods

15. Figure 16-5: Government Demand and the DD Schedule
Output, Y
Aggregate demand, D
D = Y
D(E0P*/P, Y – T, I, G2)
Government
spending rises Y2
D(E0P*/P, Y – T, I, G1) Y1
A rise in G to G2
raises Y at every
Level of E. Thus
DD shifts to right Y1 Y2
Output, Y
Exchange rate, E
DD1
DD2 E0 1 2

16. SR Equilibrium for Assets
Asset market equilibrium=equilibrium in both FX market and M market.
FX market : interest parity determines equilibrium. R = R* + (Ee – E)/E
Money market: real money supply and demand determine equilibrium Ms/P = L(R, Y)
When ↑Y → ↑ L (real money demand)
leading to a ↑ in R, leading to ↓ E, appreciation of the domestic currency.
When ↓ Y, E ↑, the domestic currency depreciates.
***A market equilibrium (AA): an inverse relation between Y and E, AA slopes downward***

17. Figure 16-6: Output and the Exchange Rate in Asset Market Equilibrium
Real domestic money holdings
Domestic interest
rate, R
Exchange Rate, E
Foreign
exchange
market R2 E1 1' E2 2'
Domestic-currency
return on foreign-
currency deposits
Money
market 1 R1
L(R, Y1)
Output rises
L(R, Y2)
Real money
supply MS P 2

18. Figure 16-6: Output and the Exchange Rate in Asset Market Equilibrium
Real domestic money holdings
Domestic interest
rate, R E R2 E1 1' E2 2'
Domestic-currency
return on foreign-
currency deposits 1 R1
L(R, Y)
M/P MS P
M/P MS P 2

19. Figure 16-7: The AA Schedule
{E1,Y1}=equilibrium Y in M market and
Equilibrium E in FX market
Output, Y
Exchange
Rate, E
AA negatively sloped
because equilibrium in
A markets lead to a negative
relation between Y and E:
↑Y → XD for M→↑R and ↓E AA Y1 E1 1 Y2 E2 2

20. Shifting the AA Curve ↑ MS →↓R then: ↑ E for every Y or
↑ Y for every E
→AA shifts up (right).
AA’ AA Y1
XS of M reduces R. US assets become less attractive, investors
switch to foreign assets, sell $, the US$ depreciates for given Y Y2

21. Shifting the AA Curve
Factors other than the exchange rate causing a fall in real money demand, rise in MS, or a rise in foreign currency returns, shift the AA schedule to the right:
↓ in domestic prices P: An decrease in P increases M/P, decreases R, causing the $ to depreciate (a rise in E): the AA curve shifts up (right).
↑ Ee: if markets expect the $ to depreciate in the future, foreign assets become more attractive, causing the US$ to depreciate (a rise in E): the AA curve shifts up (right).
↑ in R*: foreign assets become more attractive, leading to a depreciation of the US$ (a rise in E): the AA curve shifts up (right).
A structural ↓ in real money demand or a rise in real MS: if domestic residents are willing to hold lower real money balances, R falls, leading to a depreciation of the US$ (a rise in E): the AA curve shifts up (right).

22. Putting the DD and AA Curves Together:
A short run equilibrium means the nominal exchange rate E and level of output Y such that:
equilibrium in the output markets holds: AD=AS.
equilibrium in the FX markets holds (UIRP): R=R*+x.
equilibrium in the M market holds: M/P=L(.) Real money supply=Real money demand.
A short run equilibrium occurs at the intersection of the DD and AA curves
output market equilibrium holds on the DD curve
asset market equilibrium holds on the AA curve

23. Figure 16-8: Short-Run Equilibrium of Output and Asset Market:
the intersection of the DD and AA curves
Output, Y
Exchange
Rate, E DD AA Y1 E1 1

24. Figure 16-9: How the Economy Reaches Its Short-Run Equilibrium
Output, Y
Exchange
Rate, E
E adjusts immediately so that asset markets are in equilibrium. DD 2 E2 AA
The US$ appreciates and Y increases until output markets are in equilibrium 3 E3 Y1 E1 1

25. Temporary Changes in Monetary Policy (MP) and Fiscal Policy (FP)
MP: policy in which the central bank (CB) influences the MS: MP primarily influences asset markets (Money market and FX market).
FP: policy in which governments (fiscal authorities) influence the amount of government purchases G and taxes T. FP primarily influences AD and Y.
Temporary policy changes are expected to be reversed in the near future and thus do not affect Ee, expectations about exchange rates in the long run. We also assume policy changes not to affect R* and P*(a reasonable assumption for a small economy; less realistic for a large economy.)

26. Temporary Changes in Monetary Policy:
A change in monetary policy shifts the AA curve but leaves the DD curve unchanged.
An increase in MS (i.e., expansionary MP) creates an XS of M which lowers R.
As a result, E depreciates (i.e., home products become cheaper relative to foreign products) and AD increases.
A temporary expansionary MP increases Y and depreciates E .

27. Figure 16-10: Effects of a Temporary Increase in the Money Supply
Output, Y
Exchange
Rate, E DD
AA2
AA1 Y2 E2 2 1 E1 Y1

28. Temporary Changes in Fiscal Policy:
A change in FP shifts the DD curve but leaves the AA curve unchanged.
An increase in G, a cut in T, or a combination of the two (i.e., expansionary FP) shifts DD to right, increases Y, raises the transactions demand for real money balances (MD), which in turn increases R.
As a result, E appreciates.
A temporary expansionary FP increases Y and appreciates the currency.

29. Figure 16-11: Effects of a Temporary Fiscal Expansion
Output, Y E
DD1
DD2 AA Y1 E1 1 2 Y2 E2

30. Government policies may help maintain full employment:
Resources used in the production process can either be over-employed or under-employed. When resources are employed at their normal (or long run) level, the economy operates at full employment” YF.
If Y<YF, few hours worked, lower than normal output produced resulting in high unemployment.
If Y>YF employment is above full employment, many overtime hours, higher than normal output produced resulting in inflationary pressures.

31. Government policies may help maintain full employment:
Temporary disturbances leading to recessions can be offset through expansionary MP or FP.
Temporary disturbances leading to overemployment can be offset through contractionary MP or FP.
However, we must use policies that correct for the “right” shock:
In response to lower demand for domestic Y (e.g., a fall in world demand), FP must expand: expansionary MP would further weaken E.
In response to higher demand for domestic currency (e.g., from foreign investors), MP must expand: expansionary FP would further strengthen E.

32. Figure 16-12: Maintaining full Employment After a Temporary
Figure 16-12: Maintaining full Employment After a Temporary Fall in Demand for Domestic Products
A fall in world demand for
our output shifts DD to DD2,
Y falls to Y2 below Yf,
E depreciates to E2.
Output, Y
Exchange
Rate, E
DD2
AA2
DD1
Temporary fiscal expansion
restores eq’m back to 1, no
Change in E
AA1 Yf 3 E3
Temporary monetary expansion
restores Y back to Yf but
causes further E
depreciation. Y2 E2 2 1 E1

33. Figure 16-13: Maintaining Full Employment After a Temporary
Increase in Money Demand
Output, Y
Exchange
Rate, E
DD1
AA1
DD2
A rise in money demand
shifts AA to AA2,
Y falls to Y2 below Yf,
E appreciates to E2.
AA2 1 E1 Yf Y2 E2 2
Temporary monetary expansion restores eq’m back to 1, no change in E. 3 E3
Temporary fiscal expansion restores eq’m back to 1, but E
appreciates further.

34. Problems in policy implementation:
Inflation bias: Government may try to take advantage of sticky prices by pursuing expansionary monetary policy. But if the public anticipates this strategy, it will bargain for higher wages, causing higher prices and no output gain.
It may be difficult to trace the source of shocks to either output or asset markets.
Fiscal policy has an impact on the government budget: it may have to be reverted in the future, or it may be offset by changes in private savings (“Ricardian equivalence”).
Time lags in implementing policies: fiscal policy changes are often slow to be agreed upon; monetary policy changes have often effect with long lags.

35. Short Run Effects of Permanent Shifts in Monetary and Fiscal Policy
Permanent policy shifts affect the long-run E and, therefore, the future expected exchange rate, Ee.
Permanent Monetary Expansion (increase in money supply) has the following SR effects:
lowers R and makes people expect a future depreciation of the domestic currency, increasing the expected return of foreign currency deposits.
E and Y rise more than the case when expectations are constant (Chapter 14 results).
The AA curve right (point 3) more than the case when expectations are held constant (point 2).

36. Figure 16-14: Short-Run Effects of a Permanent Increase
Figure 16-14: Short-Run Effects of a Permanent Increase in Money Supply
Output, Y
Exchange
Rate, E
DD1
AA2 Yf
AA1 Y2 E2 3 2 1 E1

37. Long-Run Effects of Permanent Changes in Monetary Policy
With employment and hours above their normal levels, there is a tendency for wages to rise over time.
With strong demand for Y and with increasing wages, producers have an incentive to raise output prices over time.
Both higher wages and higher output prices are reflected in a higher price level.
What are the effects of rising prices?

38. Figure 16-15: Long-Run Adjustment to a Permanent Increase
Figure 16-15: Long-Run Adjustment to a Permanent Increase in Money Supply
As P rises,
1. EP*/P falls (real
appreciation), loss of
Competitiveness, CA
deteriorates, AD
falls and DD shifts to left.
2. M/P falls, AA shifts to
left. As R rises, E
appreciates also.
Output, Y
Exchange
Rate, E
DD2
AA2 Yf
DD1
AA3
AA1 Y2 E2 2 4 E4 E1 1
If the horizontal shift of AA
is larger than that of DD,
we observe overshooting
of E by E2-E4. Otherwise,
Undershooting occurs.
Y goes back to Yf

39. Effects of Permanent Changes in Fiscal Policy
A permanent increase in G or reduction in T
Effect on goods market: AD rises, DD shifts to right.
Effect on asset market: people expect a domestic currency appreciation in the short run due to increased AD, Ee falls, thereby reducing the expected return on foreign currency deposits, AA shifts to left
The second shift offsets the first shift: the shift in exchange rate expectation limits the expansionary effect of FP: it “crowds out” AD for domestic products, by making them more expensive internationally.
When the economy starts at full employment, the offset is complete: permanent fiscal expansions have no effect on output.

40. Figure 16-16: Effects of a Permanent Fiscal Expansion
Output, Y
Exchange
Rate, E
DD1
AA1
DD2
2: Temporary fiscal
expansion
AA2 Yf 1 E1
3: new equilibrium
with permanent
fiscal expansion.
If we start at Yf, the
effect of permanent
fiscal expansion is
zero. 2 3 E2

41. Macroeconomic Policies and the Current Account
We study the current account effect of policies by including in the DD-AA model a schedule XX showing combinations of E and Y at which CA equals its “desired” level X:
CA( EP*/P, Y-T ) = X
X may be zero; or less than zero, for a developing economy that needs foreign capital to finance growth; or greater than zero, for a mature economy repaying foreign debt.
The schedule XX slopes upward (ΔE/ΔY>0) because a rise in Y raises imports and thereby worsens the CA thus E must rise to restore equilibrium.

42. The XX schedule is flatter than the DD schedule:
XX schedule: as Y rises CA goes into deficit and hence E must rise to bring it back to its desired level (X).
DD schedule: as Y rises CA goes into deficit and AD falls. But a rise in Y also creates excess supply in goods market (saving). Thus, in order to equate AD to Y, E must rise not only to clear the CA component of AD but also to remove the excess supply by increasing foreigners’ demand for our product and thus AD further.
Hence when Y rises, the rise in E is higher for DD than for XX. ΔE/ΔYslope XX < ΔE/ΔYslope DD.
Note: CA need not be = 0 at the short run equilibrium. For simplicity, however, we suppose that it is.

43. Equilibrium and the Current Account
Output, Y
Exchange
Rate, E DD
On any point above XX,
CA is in surplus: For given
Y, a rise in E leads to CA+ XX AA Yf E1 1
On any point below XX,
CA is in deficit: for given
E, a rise in Y leads to a CA-

44. Macroeconomic Policies and the CA
Policies affect the CA through their influence on the value of the domestic currency.
A monetary expansion depreciates the domestic currency and often increases the CA+ in the short run (point 2 in Figure 16-17).
A fiscal expansion (increase in government purchases or decrease in taxes) appreciates the currency and worsens the CA
A temporary expansion shifts the DD schedule to the right (point 3 in Figure 16-17).
A permanent expansion shifts both the AA and the DD schedules (point 4 in Figure 16-17).

45. Figure 16-17: Macroeconomic Policies and the Current Account
Output, Y
Exchange
Rate, E DD
2: CA+ Temporary
expansion in monetary
policy. XX AA 2
3: CA- Temporary
expansion in fiscal policy Yf E1 1 3
4: CA- Permanent
expansion in fiscal policy 4

46. Gradual Trade Adjustment, the CA and the J-Curve
The DD-AA model assumes real depreciations (rise in EP*/P) to improve the CA immediately (vice versa for appreciations).
However, the volume of imports and exports responds slowly to a change in the real exchange rate. But the value of imports become immediately more expensive. A depreciation may then have an initial negative effect on the CA.
Thus the CA may follow a J-curve pattern after a real currency depreciation:
First the CA worsens, as the price of import rises and export and import volumes have not yet responded.
Next, the CA begins to improve, as the volume of export rises and the volume of import falls.
Empirical evidence is for most industrial countries’ CA to start improving beginning about a year after a devaluation.

47. Figure 16-18: The J-Curve Current account (in domestic output units)
Time
Current account (in
domestic output units)
Long-run
effect of real
depreciation
on the current
account
Volume effect
dominates the
value effect 1 3 2
Value effect
dominates the
volume effect.
Real depreciation takes place and J-curve begins
End of J-curve

48. Pass Through Effect
Pass through from the exchange rate to import prices measures the percentage by which dollar import prices rise when the dollar depreciates by 1%.
If Pm$=E.Pm* (where Pm$=dollar price of imports, Pm*=foreign price of imports) then pass through shows by how much Pm$ rises when E rises by 1%.
In the DD-AA model, the pass through rate is 100%: import prices in domestic currency exactly match a depreciation of the domestic currency: ΔPm$/ΔE=1
In reality, pass through may be less than 100% due to price discrimination in different countries.
firms that set prices may decide not to match changes in the exchange rate with changes in prices of foreign products denominated in domestic currency.

49. Pass Through and the J-curve
If prices of foreign products in domestic currency do not change much because of a pass through rate less than 100%, then the
value of imports will not rise much after a domestic currency depreciation, and the current account will not fall much, making the J-curve effect smaller.
volume of imports and exports will not adjust much over time since domestic currency prices do not change much.
Pass through less than 100% dampens the effect of depreciation or appreciation on the current account.