1. 1 A Short-Run Model of an Open Economy MBA 774 Macroeconomics Class Notes - Part 4

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

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

4. 4 Aggregate Demand 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. 5 Aggregate Demand Let’s review D = D(E, Y-T, I, G) Increasing the real exchange rate increases D through the current account Increasing income will –increase D through increases in consumption demand –decrease D through increasing import demand –The consumption demand effect will be greater then the import demand effect so an increase in income will increase aggregate demand Increasing investment demand I increases D Increasing government demand G increases D

6. 6 Aggregate Demand and Output Aggregate Demand (D) Real Income (Y) 45 o Aggregate Demand D(E,Y-T, I, G)

7. 7 Equilibrium in the Output Market Equilibrium in the domestic output market will occur when aggregate demand equals output (real income) In the short-run we consider prices fixed In the long-run prices will adjust

8. 8 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. 9 The DD Schedule Now we need to derive the relationship between the exchange rate and output (the DD schedule) when the output market is in equilibrium To do this consider an increase in the nominal exchange rate from E 1 to E 2 This will increase aggregate demand. Why?

10. 10 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. 11 Deriving the DD Schedule By noting the short-run equilibrium level in the output market for all levels of the nominal exchange rate we derive the DD schedule Intuitively, the DD schedule allows us to see how short-run fluctuations in the nominal exchange rate impact aggregate domestic demand

12. 12 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. 13 What Factors Shift the DD Curve? Recall where the DD curve comes from D(E,Y-T, I, G) So all of the following can shift the DD curve –Disposable income –Investment –Government spending (and taxes) –The consumption function –A demand shift between foreign and domestic consumption

14. 14 Example: Increase in Government Spending Nominal Exchange Rate (E) Y1Y1 Y2Y2 12 DD 1 DD 2 E0E0 Output

15. 15 The AA Schedule The AA schedule relates exchange rates and output levels that keep the money and foreign exchange (asset) markets in equilibrium 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) Now recall money and exchange rate market equilibrium from chapter 14 and an increase in output (Y)

16. 16 The AA Schedule

17. 17 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. 18 The AA Schedule The AA schedule describes how exchange rates fall as output increases Changes in output will result in a movement along this curve Anything that changes the stacked graphs – the foreign exchange market and money market – except output will shift the curve –A change in M S for a fixed level of Y –A change in E e –A change in the foreign interest rate R FC –A change in the real money demand function L(R LC, Y)

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

20. 20 Short-Run equilibrium Nominal Exchange Rate (E) Y1Y1 1 2 AA E2E2 Output E1E1 DD 3 E3E3

21. 21 Applications of DD-AA Model 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 –Changes in fiscal and monetary policy –Changes in world demand for domestic products –Changes in money-demand

22. 22 Monetary Policy 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. 23 Fiscal Policy 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. 24 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