1. A Short-Run Model of an Open Economy1 BA 282 Macroeconomics Class Notes - Part 4

2. A Short-Run Model of an Open Economy2 Aggregate Demand n Aggregate demand (D) is the amount of a country’s goods and services demanded by households and firms throughout the world n Recall GDP = C + I + G + EX - IM = D n Each of these components has various sources that determine demand for that factor n We will concentrate here on consumption and CA n Specifically, let’s assume C = C(Y D ) and CA = CA(E, Y D )

3. A Short-Run Model of an Open Economy3 Aggregate Demand and CA n To see how a change in E effects CA we look at EX and IM Separately. Assume an increase in E n This results in an increase in EX since domestic goods look cheaper to foreigners n This can result in an increase or decrease in IM. Why? (for now assume an increase in E results in a decrease of IM) n An increase in Y D will decrease CA. Why?

4. A Short-Run Model of an Open Economy4 Aggregate Demand n We can now write a more general function for D D = C(Y-T) + I + G + CA(E, Y-T) where Consumption demand (C) is a function of Y D Y D = Y - T (T = aggregate taxes) or more generally D = D(E, Y-T, I, G)

5. A Short-Run Model of an Open Economy5 Aggregate demand n Let’s review D = D(E, Y-T, I, G) n Increasing the real exchange rate increases D through the current account n Increasing income will n increase D through increases in consumption demand n decrease D through increasing import demand n The consumption demand effect will be greater then the import demand effect so an increase in income will increase aggregate demand n Increasing investment demand I increases D n Increasing government demand G increases D

6. A Short-Run Model of an Open Economy6 Aggregate Demand and Output Aggregate Demand (D) Real Income (Y) 45 o Aggregate Demand D(E,Y-T, I, G)

7. A Short-Run Model of an Open Economy7 Equilibrium in the Output Market n Equilibrium in the domestic output market will occur when aggregate demand equals output (real income) n In the short-run we consider prices fixed n In the long-run prices will adjust

8. A Short-Run Model of an Open Economy8 Equilibrium in the Output Market Aggregate Demand (D) Output (Y) 45 o Aggregate Demand D(E,Y-T, I, G) Aggregate Demand (D) = Aggregate Output (Y) Y1Y1 Y2Y2 Y3Y3 D1D1 D2D2 D3D3 1 2 3

9. A Short-Run Model of an Open Economy9 The DD Schedule n Now we need to derive the relationship between the exchange rate and output (the DD schedule) when the output market is in equilibrium n To do this consider an increase in the nominal exchange rate from E 1 to E 2 n This will increase aggregate demand. Why?

10. A Short-Run Model of an Open Economy10 Equilibrium Output after Currency Depreciation Aggregate Demand (D) Output (Y) 45 o Aggregate Demand D(E 1,Y-T, I, G) Y1Y1 Y2Y2 D1D1 D2D2 1 2 Aggregate Demand D(E 2,Y-T, I, G) Currency Depreciation

11. A Short-Run Model of an Open Economy11 Deriving the DD Schedule n By noting the short-run equilibrium level in the output market for all levels of the nominal exchange rate we derive the DD schedule n Intuitively, the DD schedule allows us to see how short-run fluctuations in the nominal exchange rate impact aggregate domestic demand

12. A Short-Run Model of an Open Economy12 Deriving the DD Schedule D 45 o Y1Y1 Y2Y2 D1D1 D2D2 1 2 D(E 2 ) D(E 1 ) Nominal Exchange Rate (E) Y1Y1 Y2Y2 E1E1 E2E2 1 2 Output DD

13. A Short-Run Model of an Open Economy13 What Factors Shift the DD Curve? n Recall where the DD curve comes from D(E,Y-T, I, G) n So all of the following can shift the DD curve n Disposable income n Investment n Government spending (and taxes) n The consumption function n A demand shift between foreign and domestic consumption

14. A Short-Run Model of an Open Economy14 Example: Increase in Government Spending Nominal Exchange Rate (E) Y1Y1 Y2Y2 12 DD 1 DD 2 E0E0 Output

15. A Short-Run Model of an Open Economy15 The AA Schedule n The AA schedule relates exchange rates and output levels that keep the money and foreign exchange (asset) markets in equilibrium n We start with the interest parity condition (with R FC and E e held constant), R LC = R FC + (E e -E)/E and the equilibrium money market equation M S /P LC = L(R LC,Y) n Now recall money and exchange rate market equilibrium from chapter 14 and an increase in output (Y)

16. A Short-Run Model of an Open Economy16 The AA Schedule

17. A Short-Run Model of an Open Economy17 The AA Schedule So in the short run, an increase in output decreases the exchange rate Nominal Exchange Rate (E) Y1Y1 Y2Y2 1 2 AA E1E1 Output E2E2

18. A Short-Run Model of an Open Economy18 The AA Schedule n The AA schedule describes how exchange rates fall as output increases n Changes in output will result in a movement along this curve n Anything that changes the stacked graphs – the foreign exchange market and money market – except output will shift the curve n A change in M S for a fixed level of Y n A change in E e n A change in the foreign interest rate R FC n A change in the real money demand function L(R LC, Y)

19. A Short-Run Model of an Open Economy19 Short-Run Equilibrium n We now have separate models for exchange-rate equilibrium in the n Output market (the DD schedule) n Asset market (the AA schedule) n We can combine these to get a short-run equilibrium for the whole economy n This will be the intersection of the AA and DD schedules n To see why this is the equilibrium consider an exchange rate above the AA schedule and on the left of the DD schedule

20. A Short-Run Model of an Open Economy20 Short-Run equilibrium Nominal Exchange Rate (E) Y1Y1 1 2 AA E2E2 Output E1E1 DD 3 E3E3

21. A Short-Run Model of an Open Economy21 Applications of DD-AA Model n Now that we have a general model of short-run equilibrium we can use it to explore the impact of various economic changes such as n Changes in fiscal and monetary policy n Changes in world demand for domestic products n Changes in money-demand

22. A Short-Run Model of an Open Economy22 Monetary Policy n How does a temporary increase in the domestic money supply affect the equilibrium of an open economy? E Y1Y1 1 2 AA 1 E2E2 Output E1E1 DD Y2Y2 AA 2

23. A Short-Run Model of an Open Economy23 Fiscal Policy n How does a temporary fiscal expansion (higher G and/or lower T) affect the equilibrium of an open economy? E Y1Y1 1 2 AA E2E2 Output E1E1 DD 1 Y2Y2 DD 2

24. A Short-Run Model of an Open Economy24 Fall in World Demand for Domestic Products How can monetary policy be used to restore the economy to its full- employment output level after a decline in the world demand for domestic products? E YfYf 1 2 AA 1 E3E3 Output E1E1 DD 1 Y2Y2 DD 2 3 E2E2 AA 2 Drop in World Demand Monetary Expansion