Output & the Exchange Rate Output & the Exchange Rate in the Short Runin the Short Run

• Two kinds of depreciations

Britain East Asian countriesBritain East Asian countries

92 depreciation 97 depreciation

export surged recession+inflation

??? ???output, exchange rate,

and inflation to understand

Output & exchange rate in the Output & exchange rate in the short runshort run

• Aggregate demand for an open economy’s output is the sum of:

1. consumption demand (C)

2. investment demand (I)

3. government demand (G)

4. net export demand / current account (CA)

Real exchange rate Real exchange rate changes →CAchanges →CA

• the effect of a real exchange rate change on the current account CA is ambiguousambiguous.

• other things equal, a real depreciationreal depreciation of the currency improves improves the current accountcurrent account.

Disposable income Disposable income changeschanges →CA→CA

• an increase in disposable income worsensworsens the current account.

The equation of aggregate demandThe equation of aggregate demand

),,,/*( GITYPEPDD

实际汇率实际汇率 消费消费 投资， 政府采购投资， 政府采购

),,,/*( GITYPEPDY Real output (Y) = Aggregate demand (D)Real output (Y) = Aggregate demand (D)

2 elements2 elements1: relationship between output & exchange

rate (the DDDD schedule) that must hold when the output marketoutput market is in equilibrium

2: relationship between output & exchange rate that must hold when the home home money marketmoney market & the exchange market (the asset marketasset market) are in equilibrium

Aggregate demand, DD

Output, YY

DD = YY

Aggregate demandAggregate demand

),,,/*( GITYPEPD

Fig 16-1, Aggregate Demand as a Function of OutputFig 16-1, Aggregate Demand as a Function of Output

Output↑→demand↑

OutputOutput market equilibrium in the short run: the DDDD schedule

DDDD = = relationship betweenrelationship between output output && exchange rateexchange rate

Aggregate demand, DD

Output, YY

DD = YY

Aggregate demandAggregate demand

Fig 16-3, Output effect of a currency depreciation with …Fig 16-3, Output effect of a currency depreciation with …

贬值贬值

产出增加产出增加

Deriving the DDDD schedule

• When P and P* are fixed, a depreciation of the currency leads to the higher output level.

• DDDD: all combinations of outputoutput & exchange exchange raterate

• output market is in short-run equilibrium

• aggregate demand = aggregate output

DDDDE

D

Y

Y

贬值贬值

产出增加产出增加 OutputOutput

Exchange RateExchange Rate

Output market Output market in Equilibriumin Equilibrium

Factors that shift the DDDD schedule

1. government demand, taxes, & investment

2. domestic & foreign price levels

3. variations in domestic consumption behavior

4. foreign demand for home output

),,,/*( GITYPEPD

增加政府开支，国际收支赤字增加政府开支，国际收支赤字

DDDD

DDDDE

D

Y

Y

贬值贬值

产出增加产出增加 OutputOutput

Exchange RateExchange Rate

DDDD

政府搞赤字财政政府搞赤字财政

①

②③

1. A change in G.

2. A change in TT.

3. A change in I I4. A change in PP5. A change in P*P*6. A change in the consumption functionconsumption function7. A demand shiftdemand shift between foreign & domestic

goods.

),,,/*( GITYPEPD

EY d

• Any disturbance that raises aggregate demand for domestic output shifts the DD schedule to the right;

• Any disturbance that lowers aggregate demand for domestic output shifts the DD to the left.

Asset Asset market equilibrium in the short run: the AAAA schedule

• AAAA: equilibrium in the domestic moneydomestic money market & foreign exchangeforeign exchange market.

• foreign interest rate is taken as given

),(/

/)(*

YRLPM

EEERRs

e

…The changes in the exchange rate must accompany output changes so that asset markets remain in equilibrium.

RR

EE

P

M s

Exchange Exchange marketmarket

Money marketMoney market

),( YRL

P

M s

Asset market equilibrium

①①产出增加产出增加

②② 本币升值本币升值

外汇存款本币的收益

●

●

● ●

EEee & R* fixed & R* fixed

upshotupshot

• For asset markets to remain in equilibrium:

• a rise in domestic output must be accompanied by an appreciation of the domestic currency, and vice versa.

• 本币升值本币升值 = 本币存款利息上升？本币存款利息上升？

Deriving the Deriving the AAAA Schedule Schedule

AAAA

EE

YY

Exchange RateExchange Rate

OutputOutput

①① 产出增加→产出增加→

②② 本币利率上升本币利率上升

③③ 本币升值本币升值

与与 DDDD 线最大不同：先产出，线最大不同：先产出，后升值后升值

AAAA schedule

• It relates exchange rates and output levels that keep the moneymoney and foreign exchange markets in equilibrium.

Factors that shift the AAAA schedule

1. A change in MMss . (positive correlate)

2. A change in PP. (negative correlate)

3. A change in E Eee. (positive correlate)

4. A change in R*R*. (positive correlate)

5. A change in real money demand LL(R, YR, Y).

(negatively correlate)

),(//)(* YRLPMEEERR se

short-run equilibrium for an short-run equilibrium for an open economy: open economy: DDDD + + AAAA

• Assumption: output price temporarily fixed

foreign interest rate R* fixed

expected future exchange EEe e fixed.fixed.

One-short changes→money suppliesOne-short changes→money supplies

temporary policy→no effect→temporary policy→no effect→EEee

Short-run equilibrium: intersections of DDDD and AAAA

DDDD

AAAA

EE

YY

产出市场产出市场

资产市场资产市场

调整快调整快

调整慢调整慢

saddle pointsaddle pointDDDD

AAAA

EE

YY

产出市场产出市场

资产市场资产市场

贬值打破均衡贬值打破均衡

预期升值压力预期升值压力

增产速度缓慢增产速度缓慢

① ②

③

Temporary changes in monetary & Temporary changes in monetary & fiscal policyfiscal policy

government macroeconomic policygovernment macroeconomic policy

counteracting counteracting disturbancesdisturbances

outputoutput

employmentemployment

inflationinflation

Monetary PolicyMonetary Policy

①货币供给增加②本币贬值③产出增加④远期汇率不变⑤短期效应

DDDD

AAAA

EE

YY

③

②

Fiscal PolicyFiscal Policy

①政府开支增或减少税收②提高总需求③产出增加④远期汇率不变⑤短期效应

DDDD

AAAA

EE

YY③先产出增加产出增加

后后本币升本币升值值

Policies to maintain full employmentPolicies to maintain full employment

monetary policymonetary policy

Fiscal policyFiscal policy

充分就业

充分就业

扩大需求刺激产出扩大需求刺激产出 OutputOutput

贬值扩大出口带动贬值扩大出口带动 OutputOutput

产出增加产出增加 ==就业增加？就业增加？

外需突然减少后外需突然减少后如何维持充分就业？如何维持充分就业？

DDDD

AAAA

EE

YY●

●充分就业时的产出水平充分就业时的产出水平

monetary policymonetary policy

fiscal policyfiscal policy

①①

②②

③③

fall in world demand→②fall in world demand→②

The two policies differ The two policies differ in their exchange rate in their exchange rate effects:effects:

Inflation BiasInflation Bias1. macroeconomic policy→inflation bias:

election→temptation→expansion, boom, wage demand↑→spiral →central bank independent.

2. disturbance →output market? or asset market? hard to choose monetary or fiscal policy.

3. fiscal policy →lengthy legislative deliberation; monetary policy →inflation.

4. budget deficit→not to synchronize →business cycle, election cycles.

5. lags of varying length →how much of monetary or fiscal medicine to administrate.

Permanent shifts in monetary &fiscal policyPermanent shifts in monetary &fiscal policy

Government policy instruments:Government policy instruments: money supply government spending taxes long-run exchange ratesInitial conditions or assumptionsInitial conditions or assumptions: a full employment exchange rate at long-run level domestic interest = foreign interest

A permanent increase in the Money SupplyA permanent increase in the Money Supply

upshot:

A permanent increase in Money SupplyMoney Supply must ultimately lead to a proportionalproportional rise in ExcExchange Ratehange Rate.

Ms = Ee

Adjustment to MAdjustment to Mss↑↑

• Assumption: full employment, working overtime.

• MMss has no lasting effectno lasting effect on output, relative prices, interest rate

• overshooting phenomenon will return to its full employment position.

EE

YY●充分就业水平充分就业水平

AAAA

DD

A permanent fiscal expansionfiscal expansion

• Government expenditure→aggregate demand for domestic goods and services;

• long-run appreciation of currency;

• fall of the expected future exchange rate;

EE

YY●充分就业水平充分就业水平

AAAA

DD

停留在此停留在此本币升值本币升值

ConclusionConclusion

• If the economy starts at long-run equilibrium, a permanent change in fiscal policy has no no net effect on outputnet effect on output. Instead, it causes an immediate and permanent exchange rate jumpjump that offsetsoffsets exactly the fiscal policy’s direct effect on aggregate demand.

Macroeconomic policies & Macroeconomic policies & current accountcurrent account

• Monetary & fiscal policies aimed at domestic objectives > current account.

• DD—AADD—AA model can be extended to…current account.

• DD—AA—XXDD—AA—XX model: combinations of the exchange rate and output at which the current account balance would be equal to some desired level.

XX curveXX curve

XTYPEPCA ),/*(

XXXX is flatter than DD

CA balance fall after fiscal expansions.

EE

YY

DDDD

AAAA

XXXX

CA=XCA=X

monetary monetary expansionexpansion

temporary temporary fiscal fiscal expansionexpansion

permanent permanent fiscal fiscal expansionexpansion

CA>XCA>X

CA<XCA<X

monetary expansionmonetary expansion causes the current account balance to increase in the short run.

temporary fiscal expansiontemporary fiscal expansion: There is a deterioration in the current account because the currency appreciates and income rises.

permanent fiscal expansionpermanent fiscal expansion: Expansionary fiscal policy reduces the current account balance.

DD-AA modelDD-AA model: : a real depreciation of the home currency immediately improves the current account while a real appreciation causes the current account immediately to worsen.

• …the domestic demand for domestic output rises by less than the rise in output itself (since some income is saved and income is saved and spending falls on importsspending falls on imports)

• DepreciationDepreciation of currency along DD to make export demand rise faster than import

Gradual trade flow adjustment Gradual trade flow adjustment & current account dynamics& current account dynamics

The J-CurveThe J-Curve （中文展开）If the current account initially worsens after a dep

reciation, its time pathits time path, has an initial segment reminiscent of a J.

The primary effect of the depreciation is to raise the value of the pre-contracted level of impre-contracted level of importsports in terms of domestic products.

These lags in adjustment …,

After the current account exceed its pre-depreciation level …,

Increase in CA tapers off as the adjustments to the real depreciation is completed.

If expansionary monetary policy depresses depresses output in the short runoutput in the short run, the domestic interest rate will fall farther than it normally would.

Exchange rate pass-throughpass-through & inflation

• Assumption: Nominal output prices P & P* can not suddenly jump…

• Nominal exchange rate movements affect current account in the short run.

• Linkage between the nominal nominal exchange rateexchange rate and pricesprices of exports and imports.

Pass-throughPass-through

The percentage by which import pricesimport prices rise when the home currency depreciateshome currency depreciates by one percent is known as the degree of pass-throughpass-through from the exchange rate to import prices.

PercentagePercentage???e.g. DD-AADD-AA model: degree is 11. = any

exchange rate changes is passed through completelycompletely to import prices.

Why incompleteincomplete?1. International market segmentation imperfectly competitive firms charge different

prices for the same product in different countries.

2. Firms waitwait to find out the currency movement reflects a definite trend before making price and production commitments

3. Timing of current account adjustment: 4. Currency movements have less-than-less-than-

proportionalproportional effects on the relative price determining trade volumes

Korea’s Trade Balance Korea’s Trade Balance with the U.S. and the with the U.S. and the Won/Dollar exchange Won/Dollar exchange raterate

depreciation+income cutdepreciation+income cut

Skip over Page 474-480Skip over Page 474-480

Marshall-Lerner Marshall-Lerner ConditionCondition

• The validityvalidity of the assumption: a real depreciation of a country’s currency improves its current account.

• Derive a conditioncondition on those responses.

• The Marshall-Lerner condition: all else equal, a real depreciation improves the current account if export and import volumes are sufficiently elastic with respect to exchange rate.

),/()/(),/( dd YPEPIMPEPEXYPEPCA

Foreign income is being held constant.

PEPq /

EXqIM

Imports measured in domestic output

Imports measured in foreign output unit

),()(),( dd YqEXqqEXYqCA

q

EXEX

q

EXEX

q

q

the effect of a rise in qq (a real depreciation) on exportexport demand

the effect of a rise in qq (a real depreciation) on importimport volume

++

––

12 qqq a real exchange rate changes from time 11 to time 22

贬值幅度贬值幅度

)()(

)()(12

111222

12

EXqEXqEX

EXqEXEXqEX

CACACA

Dividing through by q△q△ gives the CACA response to a change in qq,

12 )(/ EXEXqEXqCA qq

Volume effectVolume effect

>> 0 0 < 0< 0

value effectvalue effect

volume effectvolume effect vs. value value effecteffect

• Volume effectVolume effect: the effect of change in qq on the number of output unit exported and imported.

• Value effectValue effect: a rise in qq worsens the current account to the extent that it raises the domestic output value of the initial volume of imports.

ElasticityElasticity

q

q

EXEXq

EXEXq

)/(

)/(11

11

elasticity of exportexport demand

elasticity of importimport demand

12 )(/ EXEXqEXqCA qq

)/( 11 EXqmultiply its right-hand side by to express it in term

of trade elasticities.

1110 EXqEXinitiallyCA

01)/(;0/ 12 qqqCA

12,;0 qqthenqIf

the conditioncondition for an increase in qq to improve the current account is

1

1

1

It the current account is initially zeroinitially zero, a real

currency depreciationdepreciation causes a current account surplus if the sum of the relative price elasticitieselasticities of export and import demand exceeds 1.

Complexity & ConclusionComplexity & Conclusion• current account initially is non zero;

• disposable income is held constant when qq changes;

• Conclusion of empirical study:

• Most countries,

• In the long run, a real depreciation improve the current account.

1