Penn State Writing Sample --- Tutorial Class Paper
Transcript of Penn State Writing Sample --- Tutorial Class Paper
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
1/28
Ye Chen BScUniversity of Bristol
Application: Ph.D in Economics State University of Pennsylvania
Supplementary Material: Writing Sample
International Economics Tutorial Class Paper
(October, 2009)
Question:
In early 2009 the US initiated a sharp expansion of fiscal policy.
Explain the likely effects on US aggregate demand, the value of the
US dollar, and the size of its current account deficit of such a fiscal
expansion.
In February 2009, the US congress passed the $787 billion worth economic stimulus
package --- American Recovery and Reinvestment Act of 2009. By building
necessary models, this essay is to discuss the likely effects of the large fiscal
expansion has on several key factors of the US economy including aggregate demand,
the value of the US dollar, and the size of the current account deficit.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
2/28
Aggregate demand (D) is the amount of a countrys goods and services demanded by
households and firms throughout the world. A countrys overall short-run output level
depends on the aggregate demand for its products. For an open economys, the
aggregate demand is the sum of consumption demand (C), investment demand (I),
government demand (G), and the net export demand, that is, the current account (CA).
The relationship is expressed as:
D = C + I + G + CA
To determine how aggregate demand (D) changes when other factors of the economy
increase or decrease, we need to look into elements which influence the four types of
demand, or correspondingly, the four types of expenditure.
Consumption expenditure depends on disposable income, Yd (which equals national
income less taxes, Y-T). It can be written as: C = C(Y-T). The impact of increase in Yd
on consumption (C) is positive, as we know that more disposable income lead people
to spend more.
We assume that investment (I) and government expenditure (G) are given.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
3/28
The exchange rate (E) between two currencies specifies how much one currency is
worth in terms of the other. It is the value of a foreign nations currency in terms of
the home nations currency.
The current account balance (CA), viewed as the demand for a countrys exports less
that countrys own demand for imports, is determined by two main factors: the
domestic disposable income (Yd=Y-T) and the real exchange rate(EP/P), where E is
the nominal exchange rate, Pis the foreign price level, and P is the home price level.
So, CA = CA(EP/P, Yd)
An increase in real exchange rate (EP /P) means an depreciation of domestic
currency. It makes domestic goods and services cheaper relative to foreign goods and
services, which shifts both domestic and foreign spending from foreign goods to
domestic goods. As a result, exports (EX) rises and imports (IM) decreases. Therefore
the domestic countrys current account (CA) will rise. An appreciation of domestic
currency, on the other hand, will worsen the current account.
An increase in Yd causes domestic consumers to spend more on all goods, including
imports from abroad. But Yd has no influence on exports because it does not affect
foreign consumers. So a rise in Yd worsens the current account (CA).
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
4/28
Combining the four components, we can write the aggregate demand equation as:
D = C(Y-T) +I + G + CA(EP/P, Y-T)
From this expression, we can see that a rise in the government spend G will increase
the aggregate demand (D). So, the expansionary fiscal policy of the US government at
the beginning of the year (the Stimulus Package) which includes huge amount of tax
relief, investment in infrastructure, etc, will boost the aggregate demand of the US
economy in the process of the gradual recovery from the recession.
Too analyze the impact of the Stimulus Package on the US dollar exchange rate and
furthermore, the current account balance, it is convenient and important for us to
establish the diagrammatic model of AA-DD schedules.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
5/28
Aggregate DemandOutput YAggregate demandD
45Y1D1
The graph below shows the relationship between aggregate demand (D) and real
income Y for fixed values of the real exchange rate, taxes, investment demand, and
1
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
6/28
government spending. As Y rises, consumption rises by a fraction of the increase in
income, which explains that the slope of the aggregate demand curve is smaller than
1.
Equilibrium in output market requires domestic output Y to be equal to the aggregate
demand D. This is indicated by point 1, where the aggregate demand curve intersects
the 45 degree line.
Now we can look at how the exchange rate and output are simultaneously determined.
D=YAggregate DemandE2
Aggregate demand
Rise in exchange rate, E1to E2
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
7/28
45
Aggregate Demand
Y1 Output YY2
Exchange Rate
E
DD
1
2
E2
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
8/28
The above two graphs illustrate the relationship between the exchange rate and output
implied by output market equilibrium. With fixed price levels at home and abroad, the
rise in the nominal exchange rate (E1 to E2) makes domestic goods and services
cheaper relative to foreign goods and services. So the demand for domestic products
is now higher and the export will increase. However, although the amount of foreign
goods demanded by domestic consumers will decrease (volume effect), each amount
of foreign goods becomes dearer so it will cost more in terms of domestic currency
(value effect). Here we assume the volume effect is greater than the value effect and
the import decreases (Marshall Lerner Condition). The change in the exchange rate
(E1 to E2) shifts the aggregate demand curve upward. And the equilibrium output
level rises from Y1 to Y2. This explains the upward-sloping DD curve.
If we assume P and P are fixed in the short run, a depreciation of the domestic
currency (a rise in E, or E1 to E2) is associated with a rise in domestic output (Y1 to
Output YY1 Y2
E1
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
9/28
Y2), while an appreciation (a fall in E) is associated with a fall in domestic output.
This is the DD schedule shown in the lower graph (previous page).
We have derived DD schedule using the analysis of equilibrium in output market.
Now let us look at the equilibrium in the asset market.
The interest parity condition tells us that the foreign exchange market is in
equilibrium when assets or deposits of all currencies offer the same expected rate of
return when measured in terms of a common currency. This is captured in the
equation : R = R+ (Ee E)/E
where R is the interest rate on domestic currency deposits and Ris the interest rate
on foreign currency deposits. E is the spot exchange rate and Ee is the expected future
exchange rate.
The interest parity condition indicates a downward-sloping curve in the foreign
exchange market, i.e. a negative relationship between R and E, given Rand Eeare
constant. The intuition behind this is that when the domestic interest rate (R) rises, the
demand for the domestic currency will increase because it offers a higher interest.
This higher demand will drive the price of the domestic currency up and the
exchange rate (E) down.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
10/28
In the domestic money market, the condition for equilibrium is that the supply of
money equals the demand of money, i.e. Md = MS. This is captured in the equation:
Md/P = L(R, Y)
Where Md/P is the real money supply and L(R, Y) is the real money demand. The
impact of R on the value of L(R, Y) is negative because a rise in the interest rate R
makes interest-bearing non-money assets more attractive and thus lowers real money
demand L(R, Y). A rise in output Y, increases real money demand L(R, Y) by raising
the volume of monetary transactions people need.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
11/28
Money Demand Curve,
L(R, Y)
Real domestic money holdings0Exchange Rate
E
Foreign
Exchange
Market
Domestic
Money
Market
Domestic
Interest Rate,
R
Domestic-currency
return on foreign-
currency deposits
Real
Money
Supply
E1R11
Now if we combine our analysis of foreign exchange market and the domestic money
market, we can picture the asset market equilibrium in the diagram below (next page).
MSP
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
12/28
The graph above captures the analysis of domestic money market and the foreign
exchange market. The upper part of the graph indicates the relationship between
domestic interest rate R and the exchange rate E. The lower part of the graph indicates
the relationship between the domestic interest rate R and the real domestic money
holdings. The equilibrium of domestic money market (Md = MS) leads to point 1
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
13/28
where the money demand curve intersects the real money supply line. The interest
rate R1 clears the domestic money market while the exchange rate E1 clears the
foreign exchange market.
In the graph below (on the next page), a rise in output from Y1 to Y2 raises aggregate
real money demand from L(R, Y1) to L(R, Y2). For each level of interest rate people
now demand more money holdings and this shifts the money demand curve
rightwards to a new position. This new equilibrium in the domestic money market
gives a higher domestic interest rate, R2. And as the domestic interest rate rises to R2,
the foreign exchange market will correspondingly see the change in exchange rate
from E1 to E2, which indicates an appreciation of the domestic currency.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
14/28
2Real domestic money holdings0Exchange Rate
E
Foreign
Exchange
Market
Domestic
Money
Market
Domestic
Interest Rate,
R
Domestic-currency
return on foreign-
currency deposits
Real
Money
Supply
E1R11Output risesR2E2L(R, Y1)L(R, Y2)MS
P
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
15/28
Therefore, for given values of MS, P, Rand Ee, equilibrium in asset market requires
that a rise in domestic output (Y) must be accompanied by an appreciation of the
domestic currency. This relationship between output (Y) and exchange rate (E) is the
AA schedule. AA schedule can be captured by a downward sloping curve on the
following graph.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
16/28
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
17/28
Exchange rate, EOutput, YAADDE1Y1
Now that we have derived DD schedule based on equilibrium in the output market
and AA schedule based on equilibrium in the asset market, we can look at the short-
run equilibrium of the economy as a whole by combining the two equilibria.
Assuming again the domestic output prices are fixed in the short run, we can put AA-
DD schedules on the same graph below, where the intersection (point 1) indicates the
output market equilibrium and asset market equilibrium simultaneously.
1
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
18/28
Going back to our initial discussion of the effects of the US government expansionary
fiscal policy, we can use the established AA-DD schedules model to analyze them.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
19/28
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
20/28
Exchange RateEOutput YY1Y2DD11E0DD2Y1Output YY2Aggregate demandD
Government spending
rises
D=Y( US StimulusPackage )
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
21/28
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
22/28
This fiscal expansion shifts the DD schedule to the right (DD1 to DD2).
In the short run, peoples expectation on the exchange rate (Ee) does not change, and
in our discussion we mainly focus on fiscal expansion so we assume there is no
monetary policy movement (MS does not change). AA schedule therefore does not
move in the short run following the fiscal expansion. The graph below shows the shift
of DD schedule from DD1 to DD2. The exchange rate then falls from E1 to E2, which
means the US dollar will appreciate.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
23/28
AAUS Stimulus
Package
Exchange rate, EOutput, YDD1E1Y1DD2E2Y2
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
24/28
Based on the model, in the short run, as a result of the fiscal expansion the US dollar
should appreciate in value, which makes foreign goods and services cheaper, and this,
along with an income rise (Y1 to Y2), should increase imports. Exports on the other
hand, will suffer a decrease as the US goods become more expensive following a
dollar appreciation. The two effects will worsen the US current account. The
expansionary fiscal policy will therefore, reduce the US current account balance in the
short run.
In the long run, people observe the drop in the exchange rate and their expectation
(Ee) changes as well. As the expected exchange rate goes down, AA schedule will
shift downward. At the same time, the output will be adjusted to the long run natural
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
25/28
Exchange rate, EOutput, YAA1DD1E1YnDD2AA2E2E3123
level (Yn), which is the level of output that can be sustained over the long term due to
natural and institutional constraints. The economy reaches its new long run
equilibrium at point 3 in the graph on the next page.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
26/28
In the long run, the US dollar will appreciate even more than the short run (E1 to E3).
This will further worsen the US current account deficit. But the aggregate demand
comes back to the long run natural level (Yn
). This can be explained as that in the
long run, the effect of the fiscal expansion on the output level is completely offset by
the worsened current account caused by the US dollar appreciation.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
27/28
Whether this US stimulus package is a long run fiscal expansion is arguable. Some
say it is only a temporary policy because of the financial crisis while others believe it
has permanent effects to the US economy. The fact that the US dollar has actually
depreciated since the Congress passed the stimulus package might suggest that our
model does not quite fit the current real world situation. It is therefore important to
point out that although the discussion in our model focuses on the theoretical analysis
of the fiscal expansion, there are other factors in the current situation which can also
seriously influence the US aggregate demand, the value of the US dollar and the size
of the US current account deficit, e.g. monetary policies such as cutting interest rates,
US domestic inflation, etc.
However, the essay question indicates that the discussion should be in the direction of
fiscal expansion.
References:
[International Economics] Theory and Policy, Seventh Edition. Paul R. Krugman &
Maurice Obstfeld, 2006. Pearson Addison Wesley.
-
8/14/2019 Penn State Writing Sample --- Tutorial Class Paper
28/28
Flexible Exchange Rates in the Short Run, Rudiger Dornbusch & Paul Krugman.
[Brookings Papers on Economic Activity 1976] Arthur M.Okun and George L.Perry,
Editors. The Brookings Institution, Washington DC.